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How to Calculate Interest and Penalties on Unpaid Taxes
How to Calculate Interest and Penalties on Unpaid Taxes
Paying taxes can be confusing enough without having to worry about owing extra money on top of what you already owe. But if you don’t pay your taxes on time or don’t pay enough throughout the year, you may end up owing interest and penalties to the IRS or your state tax agency.
The rules around interest and penalties can be complicated, but this article will walk you through the basics of how they work and how to estimate what you might owe if you have unpaid taxes.
Why Unpaid Taxes Lead to Interest and Penalties
The government charges interest and penalties on unpaid taxes as an incentive for taxpayers to pay on time. If there were no consequences for not paying on time, many more people would likely delay or avoid paying taxes altogether!
So in a sense, the interest and penalties are there to enforce timely tax compliance. The specific rates and rules are set out in the federal and state tax codes.
IRS Interest Rates
If you owe federal income taxes and don’t pay on time, you’ll owe interest to the IRS. The interest rate is determined quarterly and compounds daily. As of Q4 2022, the annual interest rate was 6% (0.0164% daily rate).
So for every day your tax balance remains unpaid, an additional 0.0164% interest will accrue. That may not seem like much on a daily basis, but it adds up over time!
The interest rate is adjusted quarterly based on federal short-term rates and an additional 3% penalty rate. So it can fluctuate from year to year, but will virtually always be positive (meaning you owe interest).
Calculating IRS Interest
Figuring out precisely how much interest you’ll owe can be complicated because of the daily compounding. But as a rough estimate, you can take your unpaid tax balance and multiply it by the annual interest rate divided by 365.
For example, if you owed $5,000 in unpaid taxes for all of 2022 when the rate was 5%, your estimated interest owed would be:
$5,000 x (0.05 / 365) x 365 days = $250
The IRS also provides an online interest calculator where you can plug in your specific tax debt and dates to determine the interest owed.
Failure to Pay Tax Penalty
In addition to interest, you’ll also face an IRS penalty for failing to pay your taxes on time. This penalty is 0.5% of your unpaid balance for each month or partial month your payment is late, up to a maximum of 25%.
So if you’re 3 months late on paying a $5,000 tax bill, your failure to pay penalty would be:
$5,000 x 0.005 x 3 months = $75
The failure to pay penalty compounds daily as well, but stops accruing once the penalty reaches 25% of the unpaid tax.
Estimated Tax Underpayment Penalties
If you’re self-employed or have other sources of income outside of regular wages, you may have to pay quarterly estimated taxes. If you fail to pay enough estimated tax throughout the year, you may be hit with an underpayment penalty from the IRS.
The underpayment penalty is assessed if you paid less than 90% of your total tax liability or 100% of your previous year’s tax (110% if your adjusted gross income exceeds $150,000). The penalty is calculated at the normal IRS interest rate on the amount you underpaid.
So in simple terms, you’ll pay an interest-like penalty for not having paid enough tax throughout the year by making sufficient estimated payments.
State Tax Interest and Penalties
Along with federal tax obligations, you may owe interest and penalties on unpaid state taxes as well. Rules vary by state, but most states charge interest and penalties similar to federal rates.
For example, the California Franchise Tax Board imposes a 5% per month late penalty up to a maximum of 25%, along with interest compounded daily based on variable rates.
Check with your specific state tax authority to determine the applicable interest and penalty rates for unpaid balances.
Getting IRS Penalties Waived or Abated
If you do end up with tax penalties you can’t afford to pay, there may be options to get your IRS fees waived. The IRS may agree to abate penalties if you have a history of compliance and reasonable cause for the failure to pay on time.
For example, serious illness, military service, fire, flood, or other natural disaster could potentially qualify you for a penalty waiver if you request an abatement or first-time penalty relief. You typically need to submit a written reasonable cause statement with your request.
It’s still a good idea to pay as much of the interest and penalty charges as possible up front, or enter into an installment agreement, since penalties continue accruing while your request is pending.
Avoiding Tax Penalties
They best way to avoid interest and penalty charges is to pay your taxes in full and on time. If you owe money, file your return by the deadline and pay as much as possible with the return, even if you can’t pay in full.
You should then work to pay off the remaining balance as soon as possible, or set up an IRS installment agreement for monthly payments if needed.
During the year, you can also avoid underpayment penalties by paying enough estimated tax if you have self-employment or side gig income. Use Form 1040-ES to calculate and pay your quarterly estimated amounts.
While interest and penalties can’t always be avoided, understanding the rules and options for relief can help you minimize any extra charges if you do wind up with unpaid taxes.
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