How can I minimize the estimated tax penalty?

The IRS will charge you a penalty for underpayment of estimated tax when you pay too little of your total tax during the year. The penalty rate is the same as the interest rate charged by the IRS on unpaid tax.

According to the IRS, each year, about 10 million taxpayers are charged the estimated tax penalty. Most of those affected taxpayers can easily reduce or, in some cases, eliminate the penalty by increasing their withholding or adjusting estimated tax payments for the rest of the year. With a little planning, taxpayers can avoid the penalty altogether.

The IRS has a web page that has tips and resources designed to help taxpayers, including those involved in the sharing economy, better understand tax withholding, making estimated tax payments and avoiding an unexpected penalty.

Avoiding the penalty

For most people, avoiding the penalty means ensuring that at least 90 percent of their total tax liability is paid in during the year, either through income-tax withholding or by making quarterly estimated tax payments. Keep in mind exceptions to the penalty and special rules apply to some groups of taxpayers, such as farmers, fishers, casualty and disaster victims, those who recently became disabled, recent retirees, those who base their payments on last year’s tax and those who receive income unevenly during the year.

If you're an employee, you may want to consider increasing your tax withholding in the current year, especially if you had a large balance due when you filed your prior year return. You can do this by filling out a new Form W-4 and giving it to their employer. Similarly, if you receive pensions and annuities, you can make this change by filling out Form W-4P and giving it to the payer.

In either case, you can typically increase your withholding by claiming fewer allowances on their withholding form. If that’s not enough, you can also ask employers or payers to withhold an additional flat dollar amount each pay period. For help determining the right amount to withhold, check out the IRS Tax Withholding Estimator.

If you receive Social Security benefits, unemployment compensation and certain other government payments you can also choose to have federal tax taken out by filling out Form W-4 and giving it to their payer. But some restrictions apply. See the form and its instructions for details.

If your income is normally not subject to withholding, you can avoid the estimated tax penalty by making quarterly estimated tax payments to the IRS. In general, this includes investment income, such as interest, dividends, rents, royalties and capital gains, alimony and self-employment income. If you are involved in the sharing economy, you may also need to make these payments.

Tips for making estimated tax payments

Estimated tax payments are normally due on April 15, June 15, Sept. 15 and Jan. 15 of the following year. Any time one of these deadlines falls on a weekend or holiday, taxpayers have until the next business day to make the payment. For example, the 4th estimated tax payment for 2021 will be due January 15, 2022.

The best way to make estimated tax payments is to make them electronically. Paying this way ensures payments will be recorded in IRS records much faster than mailing them and with almost risk of input error.