3 Tax-Penalty Situations and How to Avoid Them

The only thing worse than owing a tax bill: owing even more when the IRS tacks on penalty charges.

The IRS has many ways to collect extra money. There are tax penalties for:

Not having health insurance.
Filing what the IRS considers a frivolous tax return.
A variety of retirement account actions or inactions.

Most taxpayers, however, tend to encounter basic tax penalties for these 3 offenses:

Not paying what is owed.
Not filing a tax return at all.
Not paying enough tax throughout the year.

Nonfiling penalty

If you don't file a Form 1040 or an extension to file using Form 4868 by April 15, the penalty for not filing starts accruing the very next day.

The assessment is 5% per month of any tax balance due. The full monthly charge for failing to file applies for any part of a month you're late in sending in your tax return. So if you file on May 1, you still are assessed the monthly 5% penalty for that month.

Many taxpayers, says enrolled agent Alan Pinck, fall into the ostrich routine, especially if they owe and can't afford to pay the due tax. They just ignore filing.

That's not a good idea for many reasons.

First, says Pinck, "you're just prolonging the inevitable." Even if you get an extension until Oct. 15 to submit your Form 1040, you'll have to make that October deadline or the nonfiling penalty will begin.

Plus, the IRS considers not filing at all the more serious offense. "It's way worse than if you didn't pay," says Stephen DeFilippis, an enrolled agent in Wheaton, Illinois.

There is one bit of good news about the nonfiling penalty: It maxes out at 25% of your unpaid taxes.

Still, 25% is a hefty fee to pay just because you didn't fill out the form on time.

Nonpayment penalty

As for those unpaid taxes, they have their own penalty.

Even if you file a return or an extension by April 15 but don't pay what you owe in April, you'll face the nonpayment penalty. The penalty is 0.5% of your due tax.

Again, this penalty is assessed for every month, or any part of a month, that your tax bill is outstanding. And like the nonfiling penalty, the nonpayment penalty can grow until it reaches 25% of your unpaid tax bill.

What if you don't owe any or very much tax? Tax law still requires you to file.

If you are due a refund, filing is the only way to get that money.

And if you owe only a small amount but wait more than 60 days to file a tax return, the minimum failure-to-file penalty is the smaller of $135 or 100% of the unpaid tax.

Percentage break for both penalties

If you did not file on time and did not pay any tax you owed, you are subject to both penalties. However, the IRS actually gives you a bit of a break in these cases.

The combined penalty for failure to file and failure to pay is 5%, the total of the 4.5% late filing charge and 0.5% for the late payment for each month or part of a month that your return is late, up to 25%.

But don't push it. If, after 5 months, you still have not filed or paid, the failure-to-file penalty will max out, but the 0.5% failure-to-pay penalty continues until the tax is paid -- up to 25%.

That means your total penalty for failure to file and pay can be as much as 47.5% -- a 22.5% late filing tax penalty and another 25% in late payment charges.

Underpayment penalty

U.S. taxes are collected on a pay-as-you-earn system. If you don't meet that requirement, you'll be hit with a tax underpayment penalty.

Most of us comply, thanks to income tax withholding from our paychecks. But if you're an independent contractor, either full time or as a side job to your salaried employment, you are responsible for covering the tax due on those earnings through estimated tax payments.

The same timely tax-paying applies to other income, such as prize winnings, investment earnings and even stock options, an income source Pinck sees often at his San Jose, California-based firm A. Pinck and Associates.

Sometimes, people who receive these various types of untaxed income pay what they owe the IRS in 1 lump sum when they file their taxes. That won't cut it.

The IRS wants its portion of your earnings when you get the money. Fail to do that and you could owe an underpayment penalty, even if you ultimately paid the full tax due.

Avoiding the underpayment penalty

There are a few ways to get around the tax underpayment penalty.

First, you can meet 1 of 2 estimated tax-filing safe harbors. Pay estimated taxes that are the lesser of 100% of your prior year's tax liability or 90% of your current year's tax liability. Most taxpayers, says DeFilippis, opt for the prior year safe harbor. "100% is a fixed target; 90% is a moving target," he says.

Just make sure when you look at your previous year's taxes, you note the correct amount to use as your safe harbor. For example, let's say your tax liability was $20,000 and you paid $18,000 during the tax year through withholding, tax credits and estimated taxes; then your tax due was $2,000. Your estimated tax safe harbor amount this year is the 20 grand, not the $2,000.

If you have a salaried job, you also can make up for a coming estimated tax shortfall by increasing your withholding there, says DeFilippis. Married couples get an extra option here. If they file jointly, a spouse's withholding will cover any shortage of estimated taxes due on the husband's or wife's untaxed income.

Or you can annualize your income. Here you file Form 2210, breaking down income and deductions by estimated tax period, showing that you paid as you should have for each. "If you got a big chunk at the end of the year, it only counts for the 4th quarter," says DeFilippis. "Annualizing shows you had the correct amount in the first 3 (quarters) and only needed to pay the higher estimated amount in the last quarter."

Other penalty options plus interest

If you face a tax penalty for the 1st time, the IRS might be lenient.

"A first-time abatement request can be made, and a lot of time the taxpayer will prevail," says Pinck. Basically, you show the IRS that you've been good for your taxes in the past and promise to be compliant in the future.

Remember, though, even if the IRS grants some penalty relief, you'll still face interest charges on unpaid taxes.

"Interest is statutory, so it's usually not abated," says Pinck. For general nonpayment, nonfiling situations, the current interest rate is 3%. It is adjusted quarterly, and the rate is posted on the IRS website.

A 3% rate doesn't sound like much, but Pinck points out that it is compounded quarterly, not annually. "It can add up pretty quick," he says.

So can the tax penalties for not filing, not paying or paying too little throughout the year. To stay out of those costly situations, file your 1040 on time, pay any taxes due with that form and keep track of and pay enough estimated taxes on your other earnings.

That will ensure that Uncle Sam doesn't get any more of your money than he should.