How to avoid the 10 most common tax penalties
In fiscal year 2017 that ended last September, 31 million taxpayers who filed individual, estate or trust tax returns faced penalties totaling more than $11 billion – and that’s just the beginning. An additional 6.7 million people paid $3.1 billion in ACA penalties, and 1.2 million people paid $1.6 billion in additional tax on early distributions from their IRAs. The bad news is that there are more kinds of penalties than many taxpayers might think. The good news is that there are ways to avoid, reduce or eliminate tax filing penalties.
Tax return penalties can impact just a few thousand people to more than 10 million and range from an average cost of $91 to more than $60,000. Here they are, ranked from most common to least common, with a few tips along the way to avoid or minimize them.
Late payment penalty (17.6 million taxpayers, $5.1 billion, average $288)
Failing to pay taxes by the April deadline is the most common reason taxpayers get IRS tax penalties. The failure-to-pay penalty is 0.5 percent of taxes due each month they go unpaid, maxing out at 25 percent.
How to avoid the failure-to-pay penalty: Pay taxes by the April deadline. If taxpayers can’t pay by the deadline, they can look into other payment options, such as using a credit card, to avoid the penalty. Taxpayers who filed an extension must pay at least 90 percent of the taxes they owe by the April deadline, or face the failure to pay penalty when they file their extended return.
How to minimize the failure-to-pay penalty: Pay as much as possible by the April due date. Taxpayers can request an extension to pay of up to 120 days, or set up a payment plan with the IRS, called an installment agreement. Many IRS installment agreements allow taxpayers to pay their taxes due over a period of up to 72 months or longer if they’re in a hardship situation. Getting into a payment plan also reduces the failure-to-pay penalty from 0.5 percent to 0.25 percent per month. The IRS offers several other options for people who owe large amounts or who are in financial hardship situations.
Estimated tax penalty (9.8 million taxpayers, $1.5 billion, average $156)
Paying taxes before the April deadline isn’t always enough to avoid penalties. Taxpayers must follow the “pay-as-you-go” rules during the year to avoid estimated tax, or underpayment, penalties. During filing, tax preparation software automatically calculates this penalty.
How to avoid the estimated tax penalty: As long as taxpayers pay (by the April deadline) 90 percent of the taxes they owe for the year or 100 percent of the taxes they owed last year, they won’t owe the penalty. Usually, taxpayers who have enough wage withholding won’t face this penalty. However, tax reform changes mean employees may need to do a withholding checkup to make sure they will avoid the penalty for 2018 returns. Self-employed people, retired people and taxpayers with other types of income (like investment income) should make sure they pay enough in quarterly estimated tax payments during the year or increase their withholding, if possible. Taxpayers rarely get abatement of the estimated tax penalty, so it’s best to find an exception when filing the return.
ACA health insurance mandate penalty (6.7 million taxpayers, $3.1 billion, average $463)
The requirement to carry minimum essential health insurance coverage came with an increasing tax penalty each year since the ACA was implemented in 2014. Although the Affordable Care Act penalty was repealed for 2019, taxpayers won’t get a pass on the requirement to have health insurance in 2017 or 2018.
How to avoid the health insurance mandate penalty: To completely avoid this penalty, taxpayers must have had minimum essential coverage for all members of the tax household all year long – or they must qualify for one of about a dozen exemptions that apply for that year.
How to minimize the health insurance mandate penalty: Qualify for an exemption for at least part of the year. For example, a taxpayer without health insurance all year who can show financial hardship for two months would only have to pay the penalty on 10 months. Also, while it is too late to get insurance for 2017, some people may still qualify for a Marketplace special enrollment period for 2018.
Late filing penalty (2.5 million taxpayers, $3 billion, average $1,196)
Failing to file a tax return is one of the most expensive mistakes a taxpayer can make. The failure-to-file penalty is 5 percent of the taxes due each month they go unpaid, maxing out at 25 percent. This is 10 times more expensive than the failure-to-pay penalty.
How to avoid the failure-to-file penalty: Even if taxpayers can’t pay their tax bill, they should still file their return. If they don’t have the time or the paperwork to file by the deadline, taxpayers can file an extension to avoid failure-to-file penalties.
How to minimize the failure-to-file penalty: Taxpayers who missed the deadline to file a return or an extension should file as soon as possible.
Early distribution penalty (1.2 million taxpayers, $1.6 billion, average $1,333)
People who save money in tax-advantaged retirement accounts, like a 401(k), generally can’t take that money out early without triggering a penalty. For example, a taxpayer who distributes funds early from an individual retirement account (IRA) to pay for a home renovation could trigger a 10-percent early distribution penalty, on top of the taxes he or she will owe on the distribution.
How to avoid the early distribution penalties: Although rules vary by the type of account, taxpayers must usually be 59½ before they can withdraw money without penalty from their retirement accounts. Depending on the plan rules, taxpayers may qualify for an early distribution penalty exception, if they’re using the money for certain purposes, like paying for college. Be aware of the exceptions, their limitations and how they apply to various plans.
Bad check penalty (655,971 taxpayers, $60 million, average $92)
The penalty for writing a bad check for taxes is either $25 or 2 percent of the check amount (whichever is more). And if the bad check causes a late payment to the IRS, taxpayers could also owe the failure-to-pay penalty, plus interest.
How to avoid the bad check penalty: If taxpayers don’t have enough money to cover their tax bill, there may be other options, such as paying with a credit card (which will incur service fees and possibly interest), or getting an alternative arrangement from the IRS, like a 120-day extension to pay or a monthly payment plan.
Accuracy penalty (557,147 taxpayers, $1.1 billion, average $1,935)
Taxpayers generally don’t need to worry about honest mistakes on a tax return triggering the expensive accuracy penalty. The accuracy penalty, 20 percent of the understatement of tax, is limited to people who leave large amounts of income off their return or who are negligent in preparing their return.
How to avoid the accuracy penalty: Taxpayers should do their best to file a complete and accurate return. When in doubt, get qualified professional’s help preparing a return.
Excess contribution tax (346,968 taxpayers, $44.1 million, average $127)
In terms of taxes, it’s possible to save too much for retirement or medical expenses. Taxpayers can contribute only a certain amount to their traditional and Roth IRAs and their health savings accounts (MSAs and HSAs). And if their income is too high, they may not be able to contribute at all. If taxpayers contribute over the limit, they’ll owe an additional tax on the excess contributions. This tax may feel like a penalty, but it’s technically an excise tax.
How to avoid the excess contributions tax: If taxpayers are eligible to contribute to these plans, they should stay within the contribution limits. In some cases, taxpayers can avoid a penalty by recharacterizing contributions, but it’s a good idea to see a professional for help doing this.
How to minimize the excess contributions tax: Withdraw the excess contributions and their earnings by the due date of the return, including extensions. The extra contributions won’t be subject to tax, but the earnings are taxable.
Penalty for not taking required minimum distributions (11,810 taxpayers, $6.8 million, average $576)
Starting at age 70½, taxpayers must start taking required minimum distributions (RMDs) from their retirement accounts. The penalty for failing to do so is 50 percent of the RMD. Taxpayers who are still working at age 70½ can delay RMDs, but only from their current employer’s retirement plan. They’ll still have to start taking RMDs from IRAs and other employer plans at age 70½.
How to avoid the RMD penalty: Taxpayers can use the RMD to make a qualified charitable distribution, which means they won’t owe taxes on the amount they contribute.
Fraud penalty (2,533 taxpayers, $157 million, average $61,962)
If accuracy penalties are expensive, fraud penalties are even steeper. Accuracy errors turn into fraud when the IRS determines that the taxpayer was intentionally evading taxes. Fraud penalties also apply to tax identity thieves who file fraudulent returns using someone else’s falsified information.
How to avoid the fraud penalty: File a complete and accurate return. Don’t fabricate deductions or alter eligibility for credits.
How to request relief for tax return penalties
The best course is to avoid penalties altogether. For people who get penalties, the IRS offers tax penalty relief in some cases. For example, if taxpayers filed or paid late, they can use reasonable cause or first-time penalty abatement to request relief.
Taxpayers can learn more about penalty relief options and how to get expert help from H&R Block’s Tax Audit & Tax Notice Services.
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