IRS Income Tax Underpayment Penalty
February 20, 2021 10:31 AM   Subscribe

Is the IRS income tax underpayment penalty based solely on income, or is it also based on IRA withdrawals?

When I retired, I rolled over to a traditional IRA the 403b account I had with my employer. In 2020, I withdrew money from the IRA. I also worked briefly as a lifeguard in 2020, earning about $600. No income tax was withheld for my lifeguard job. Upon doing my taxes, I see that I was charged an underpayment penalty of about $40. Is this underpayment penalty only directly related to my employment (because they did not withhold income tax) or is it also related to my withdrawal from my IRA account?
posted by SageTrail to Law & Government (10 answers total) 2 users marked this as a favorite
I am not an accountant, but yes any taxable income (which includes IRA distributions) needs to be paid quarterly via estimated taxes if nothing is withheld. While doing a quick search I found this decent article talking through it for retirees. Your options are to pay quarterly estimated taxes (divide your last year's income tax by 4 to be safe) via the IRS's website, ask your IRA to withhold, or just pay the fairly-low penalties in your case. I am self employed so the penalties are much higher, but I've found the IRS's estimated tax payment thing to be pretty easy to use, takes me like 15 minutes once every 3 months (make sure to print your receipt).
posted by JZig at 11:06 AM on February 20

Yeah, I don't think the IRS cares whether the specific money is from the lifeguard job or the IRA distributions, it's about the overall amount of tax that you underpaid. You can generally avoid the penalty by paying either 90% of your tax owed for the year in question (through withholding or through estimated payments) or 100% of your previous year's tax.

Did you retire in 2019 or 2020? Because if so, the IRS can waive the penalty if "You retired (after reaching age 62) or became disabled during the tax year or in the preceding tax year for which you should have made estimated payments, and the underpayment was due to reasonable cause and not willful neglect." (Topic No. 306 Penalty for Underpayment of Estimated Tax)
posted by mskyle at 11:12 AM on February 20

I retired in 2019, so I can ask the IRS to waive the penalty this time. Going forward, I think it will be better for me to pay the fairly low penalty because I assume I'll come out ahead by keeping my money invested for an entire year vs cashing in mutual funds in order to make quarterly payments.
posted by SageTrail at 12:50 PM on February 20

At the risk of putting myself in the thread-sitting category ...
In April of 2020, I withdrew $30,000 from my IRA. In Oct/Nov of 2020, I was paid a total of about $600 for my lifeguard job. So a 5% per month penalty based on my lifeguard salary alone would put the underpayment penalty amount at about my previously stated $40-ish, which leads me to believe there is no a tax penalty related to IRA withdrawals. (But I could be wrong; it certainly wouldn't be the first time!)
posted by SageTrail at 3:08 PM on February 20

Agreeing with the above answers that all income is subject to the underpayment fee. It is very common in years with retirement and employment income, but even if you just have retirement income, it can still apply.

This is not a late payment fee - this an underpayment fee, which is different. You can't owe a late fee for 2020 taxes yet since the filing season has not ended. If you will be taking a regular distribution from your account in the future, you can ask that they withhold money from it for taxes at that time. If you want to bet the return on your money will beat your penalty, I'd keep a close eye on it every year.
posted by soelo at 3:16 PM on February 20

The IRS says: Generally, most taxpayers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and refundable credits, or if they paid withholding and estimated tax of at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller.

which suggests to me that the total taxes underpaid must be off by more than a $1000 so you messed up on your withholding for the IRA since there is no way the taxes on $600 of lifeguard income is enough to make you underwitheld.

Legally, you face additional penalties if you are knowingly not making estimated tax payments when obligated to do so. So the strategy to hold on to your tax money just pay the penalty can land you in more trouble. The safe harbor (in other words, if you get it wrong, you just pay what you owe with no extra penalty) is to make sure you pay at 90% of what you are going to owe as you go or pay at least 100% of last year's taxes.
posted by metahawk at 3:57 PM on February 20 [3 favorites]

Also to be clear: the 5% penalty is on the unpaid *taxes*, not on the income. So yes, 5% of $600 is almost $40, but it's not your income that matters here, just your underpaid taxes.

You should try to avoid the penalty - it's priced very high in order to motivate you to *not* keep your money until you file.
posted by mskyle at 4:10 AM on February 21

I finally found this underpayment formula via google:
For payments of $1,250 or more, the penalty is 2% of the amount of the payment. For payments less than $1,250, the penalty is the amount of the payment or $25, whichever is less.
My tax underpayment was around $2000-ish. And 2% of $2000 = $40.
Had I made quarterly payments of $500 each throughout 2020, I would have avoided the $40 penalty.
posted by SageTrail at 9:40 AM on February 21

Your penalty was assessed at a certain amount and due at the end of the year and then accrued interest from that point forward. It could have been at separate points within the year or just the last quarter forward but highly unlikely to be from the wages earned as a lifeguard over a summer.
posted by The_imp_inimpossible at 3:11 AM on February 22

Yes, I now know that I was supposed to make quarterly tax payments based on estimated taxes due for my IRA withdrawal as well as my lifeguard job (since my lifeguard employer did not withhold any income tax).
posted by SageTrail at 5:29 PM on February 22

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