Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part VII. Other Important Things to Know
Chapter 32. Penalties and Interest
Be Careful—They Carry a Punch
Ignore them long enough and they will go away, right? Not if you’re talking about talking about the IRS or the penalties and interest that they can levy. The longer you ignore them, the worse it gets and the worse they get. I have had several new clients come to me who are at the point of receiving serious threats from the IRS because they have not filed tax returns for a few years. Once we compile all of their missing returns it is often the case that they owe more money from penalties and interest than they owed in taxes!
Not all penalties are equal either. Certain penalties can be relatively benign, while others are downright vicious. It is good to understand the consequences of each of these penalties so that you can make informed decisions in your dealings with the IRS. This chapter covers the following topics:
· Failure to File Penalty
· Failure to Pay Penalty
· Underpayment of Estimated Tax Penalty
· Early withdrawal from retirement accounts
· Unqualified withdrawal from a Health Savings Account (HSA)
· Excess contribution to retirement accounts
· Penalty abatement
Failure to File Penalty
One thing I try to make very clear to people is that even when you don’t have money to pay your taxes you should still file a return. Not filing a return is a terrible mistake. One reason is that once you file a return the IRS’s clock starts ticking on the amount of time it has to audit or adjust your return. Once you file the return the IRS has only three years from the date of filing, or the due date (whichever is later) to audit your return (assuming you have not made serious omissions or committed fraud). If you do not file a return, the IRS has until the day you die (actually, a little longer) to assess the taxes it believes you owe!
The second reason to file a return is that the Failure to File Penalty is very steep. The penalty is 5% of the taxes due for every month (or portion thereof) that the return is late. The maximum penalty is 25%, so if you are more than five months late you will receive the maximum 25% penalty.
The best defense against incurring this penalty is to file for an automatic six-month extension of time to prepare and file your return before the original due date of the return, which is April 15. This extension gives you up to October 15 to pull everything together. Be sure to file a return by that extended date, though, because if you file after it the extension becomes void and the failure to file penalty time line reverts back to the original due date of the return.
The penalties for not paying the taxes you owe are much smaller than the penalty for not filing (and you will eventually pay for both whether you file or not). For this reason you should always file the return before the extended due date and save yourself an automatic 25% increase in the amount you owe (plus interest).
If you are owed a refund on your tax return there is no Failure to File Penalty, since the penalty is based on the amount that you owe. However, you must file within three years of the due date for the return in order to receive the refund; otherwise the IRS gets to keep it (and is still able to come after you to file a return). While you may wonder why someone would not file a return if he/she is owed a refund, I have actually seen it a surprising number of times.
Failure to Pay Penalty
If you are unable to pay the taxes that you owe by April 15 you will be subject to the Failure to Pay Penalty. This penalty is 0.5% of the tax that you owe, charged every month (or portion thereof) on the outstanding balance until the tax is paid in full. There is no maximum amount that can be charged for this penalty—it will continue to accumulate indefinitely until you pay the tax.
Caution There is a common misunderstanding that filing for an extension of time to prepare your tax return also gives you an extension of time to pay your taxes. This is not true. Any taxes that you owe at the time of filing (after the original due date) will be subject to the Failure to Pay Penalty. For this reason you should always make your best guess about the amount of tax you will owe and pay that amount by April 15, even if you will file your tax return at a later date.
Underpayment of Estimated Tax Penalty
The tax code calls for a pay-as-you-go system. You are required to pay taxes throughout the year based on what your total tax bill will be at the end of the year. If your estimate is wrong and you pay too little, you will pay a penalty on the difference.
Example Max’s total tax obligation is $12,000 at the end of the year, which means he should have paid $1,000 per month (or really $3,000 per quarter) in estimated payments as he went through the year. Max underestimated his tax obligation and only paid $8,000, so he will pay penalties on the $4,000 shortfall.
The penalty is essentially an interest payment. The penalty rate is set each quarter and is based on the going interest rate for treasury bills. Your penalty is calculated against the total quarterly shortfall. The quarterly payments are due on April 15, June 15, September 15, and January 15. The late date of April 15 allows you to complete your previous year’s tax return so that you have a number to base your payments on. The late date of January 15 allows you time to figure out your actual total income for the year. The other two dates (June and September) fall on the last month of each quarter. Why don’t they just use April, July, October, and January to make it every three months? Who knows? Maybe it would make things too simple.
Example Max underpaid his estimated payments by $1,000 per quarter. He will have to calculate the penalty on each quarterly payment separately, based on the number of days between the due date of that payment and the day that the payment was actually made (i.e., 365 days between the first underpayment of $1,000 that was due on April 15 and the actual payment date of April 15 the following year; 304 days between June 15 and April 15; 212 days between September 15 and April 15; 90 days between January 15 and April 15). Each of these numbers of days would be used to calculate the pro-rated penalty that should be charged on each under payment. If the penalty rate were 4% during this time, Max’s total late penalty would be $106.
As you can see from the example, this penalty is not tremendously punitive. If you are making estimated payments that are fairly close to the real amount you will owe, not having certainty is nothing to lose sleep over. In fact, I know some people who feel like they can earn more money from their investments than the IRS will charge them for penalties, so they just wait to pay their taxes each year and pay whatever penalty comes. I don’t necessarily recommend that, but I can see why they do it.
If trying to estimate what your tax payments should be each quarter sounds like too much work, the good news is that the IRS has provided a safe harbor. As long as your estimated payments equal at least 90% of what you actually owe, there is no penalty. As an alternative, you can pay 100% of your tax obligation from the previous year, which will eliminate estimated payment penalties for you—no matter what your actual bill ends up being. If your Adjusted Gross Income (AGI) was over $150,000 you must pay 110% of the previous year’s tab in order to take advantage of this safe harbor.
Another time in which no penalties are charged is if the amount you owe after estimated payments is less than $1,000. This is the case regardless of whether you have paid 90% of your total bill, or 100%/110% of last year’s bill.
These estimated payments can be made through withholdings from your paycheck, or through making quarterly payments directly to the IRS. An important note is that the IRS considers all withholdings to have been paid evenly throughout the year, regardless of when they were actually paid. It is especially important for business owners to know that they could conceivably make no estimated payments during the year, then pay themselves through payroll at the end of the year, withholding a sufficient amount to cover the estimated payments. In doing so the IRS would treat the payments as if they had been made on time and not calculate penalties on the first three quarterly payments.
Finally, if you own a business and your income is highly variable, you are not required to make payments of equal amounts each quarter. What you may do instead is use your year-to-date income numbers each quarter and annualize them to estimate what your tax payment should be, based on those annualized numbers.
On top of all of the other potential penalties and interest that may be levied on you, the IRS will also charge you interest on the tax you owe. The interest will compound and accumulate until your entire bill is paid. The interest rate is based on the rates of current treasury bills and is set on a quarterly basis.
Early Withdrawal from Retirement Accounts
The government does not want you to take money out of your qualified retirement accounts before you reach retirement age (meaning, you remove money from the account before you reach the age of 59½). If they did not prevent you from removing funds from your retirement account you would be able to manipulate your tax return by claiming deductions for contributions in a high-tax year and then withdrawing those contributions in a lower-tax year. For this reason the IRS has imposed a 10% penalty tax for withdrawing money early from a qualified account.
Caution In the case of the Savings Incentive Match Plan for Employees (SIMPLE) IRA, the 10% early withdrawal penalty is actually increased to 25% if the money is moved out of the plan in the first two years.
Note 457(b) plans are the only type of qualified retirement account that does not have a 10% penalty for early withdrawals.
The tax code does provide opportunities to make penalty-free withdrawals in certain circumstances. These exceptions available for employer-sponsored retirement plans are:
· Withdrawals that are rolled into another retirement plan within 60 days (this may be done only once per year)
· Distributions upon the death or permanent disability of the account owner
· Distributions upon separation of employment if the account owner is 55 years old (or older)
· Distributions to a spouse by a court order in a divorce
· Distributions up to the amount of deductible medical expenses during the year (whether or not deductions are itemized on the return)
· Distributions due to an IRS levy (at least they don’t penalize you when they take your retirement money)
· Distributions made as substantially equal periodic payments over the expected lifetime of the owner
Caution The exception which allows for “substantially equal” withdrawals of the owner’s expected lifetime can be very tricky to orchestrate and carries significant financial risk. If you plan to withdraw funds under this rule, be sure to hire a very competent professional to help you.
For non-employer–sponsored, traditional IRA accounts, all of the afore-mentioned exceptions apply, except the one regarding separation from service after age 55. In addition to that list there are a few other times when you can remove money from a traditional IRA without incurring the penalty. They include:
· Insurance premiums for unemployed individuals
· First-time home buyer’s expenses. (The exception is for withdrawals up to a maximum of $10,000, and only once in an individual’s lifetime. It is also worth noting that a “first-time” home buyer is one who has not owned a home in the previous two years—not necessarily limited to the truly first-time buyer.)
· Education expenses (discussed more in Chapter 13)
Tip If you need to withdraw money from an employer-sponsored plan, such as a 401(k), but do not qualify for the exceptions, you may still have another option. If you are no longer working for the employer who sponsored the plan you can first roll the money into an IRA and then withdraw the money under one of the IRA penalty exceptions.
If you are still employed with the company, check with the Human Resources Department to see if the retirement plan allows for loans to be taken from the funds. Many plans do allow for loans, which gives you the opportunity to withdraw funds without incurring taxes or penalties.
To qualify as a first-time home buyer, you can purchase the home for yourself, your spouse, your children, your grandchildren, or a living ancestor of you or your spouse. The “first-time” status is based on the purchaser, not the resident or owner.
The first-time home buyer exception is for a principal residence. You could own a rental property and not own a principal residence, and you would still qualify for the exception when you buy a new home.
When withdrawing money from a retirement account, be sure to withhold enough taxes from the withdrawal to cover your additional tax liability at the end of the year, in order to avoid penalties and interest that are imposed on late payments of taxes. Also, If you take an early distribution be sure to pay for all your medical bills and other “exceptions” before the year’s end to ensure that you utilize as much of the exemption as possible.
Unqualified Withdrawal from a Health Savings Account (HSA)
If you remove money from an HSA account for something other than qualified medical expenses before you are 59½, you will pay a 20% penalty on that withdrawal. However, it is important to note that the IRS only asks you to report your total qualified medical expenses and your total withdrawals during the year. So, if you accidentally use your HSA debit card at the gas station, just be sure that you pay for an equal amount of qualified medical expenses during the year using non-HSA money. If you do so, the two expenses will cancel out and you will not need to pay the penalty. Of course, I don’t recommend this be your standard operating procedure. For information on what medical expenses qualify, see Chapter 26.
Excess Contribution to Retirement Accounts
If you accidentally contribute more than the maximum amount allowed to an IRA or employer-sponsored retirement plan, be sure to correct that mistake as soon as possible. If you correct the error by April 15 of the following year you will not owe any penalties.
Note When removing excess contributions from a qualified retirement account you must also remove any gains that are attributable to those contributions. This eliminates the temptation to overfund an account at the beginning of each year and keep the gains in the account.
The IRS is allowed to waive or reduce some of the penalties but not others. They key to getting penalties abated is having a really good reason—one that shows you had reasonable cause and that your reason for being penalized was not caused by willful neglect. The IRS considers requests for penalty abatement on a case-by-case basis, but a few things will play in your favor:
· There was a specific incident or event that prevented you from complying with the rules (a great example would be that you were in a coma from April 1 to May 1 and unable to file your return).
· You complied with the rules as soon as you were able to, or once the error was discovered.
· You have a good history of complying with the tax laws.
· For an accuracy-related penalty, you can show that you had good cause for your original position and that you were acting in good faith.
If your penalties are significant and you believe that you have a good reason for them to be abated, it may be worthwhile to hire a professional who is experienced in penalty abatements to help you.