The United States has a “pay as you go” tax system in which payments for income tax (and, where applicable, Social Security and Medicare taxes) must be made to the IRS throughout the year as income is earned, whether through withholding, by making estimated tax payments, or both.

Individuals and corporations that underpay their taxes during the year are assessed estimated tax penalties by the IRS. The estimated tax penalty (also called the “underpayment penalty”) is calculated separately for each quarter based on the amount of unpaid tax for that quarter.

The penalty equals the federal short-term interest rate (in the first month of the quarter in which taxes were not paid) plus 3 percent.1

The federal short-term interest rate changes from time to time based on interest rates generally. Thus, the estimated tax penalty amount changes as well. For many years, while inflation and interest rates were low, the estimated tax penalty was also low.

As recently as 2022, it was only 3 percent.

But with the rapid rise in interest rates, the penalty has also risen. The estimated tax penalty is a whopping 8 percent from October 1, 2023, through March 31, 20242—the highest it has been since 2007.

As we explain later, the penalty is not deductible, so your effective penalty rate is much higher than the 8 percent.

With this high penalty rate, avoiding it by paying enough tax during the year makes sense. If you fail, ... Log in to view full article.