Underpayment Penalty

What it means

The government wants you to pay your taxes as you earn money throughout the year, rather than all at once in April. If your employer does not take out enough tax from your paycheck—which can happen when you sell stock—the IRS may charge you an extra fee called an Underpayment Penalty.

This penalty is like interest on a loan you didn't know you had. It is calculated for each quarter based on federal rates until you pay what you owe. You can avoid this fee by using a 'Safe Harbor,' which means you paid at least 90% of your total tax bill for the current year or 100% of the tax you owed last year.

A simple example

Imagine Sam owes $10,000 in taxes for the year. By April, his employer had only taken out $6,000 from his paychecks. Sam is short by $4,000. Because he didn't pay enough along the way, the IRS will charge him a small interest-like fee on that $4,000 shortfall for each month it was unpaid.

Why it matters to you

• You could lose extra money to unnecessary government fees.
• You may need to plan ahead if you expect a large income from selling stock.
• You can avoid the fee if you make Estimated Tax Payments when your paycheck withholding is too low.
• A tax professional can help you calculate if you are on track to avoid this penalty.

Common mistakes to avoid

• Assuming that taxes on stock sales are automatically paid by your employer.
• Forgetting that large stock profits can push you into a higher tax bracket.
• Waiting until the end of the year to check if you have paid enough tax.

Words used on this page

• Estimated Tax Payments: Money you send directly to the IRS during the year when your employer does not take out enough tax.
• Withholding: The amount of tax your employer takes directly out of your paycheck to pay your taxes for you.
• Safe Harbor: A rule that lets you avoid penalties if you pay a specific minimum amount of tax by certain deadlines.
• Quarter: A three-month period used by the IRS to track when taxes are earned and paid.