Every year, millions of taxpayers in the United States are required to pay estimated taxes to the Internal Revenue Service (IRS). These taxpayers are self-employed, receive income from a source other than a traditional employer, or receive a large amount of investment income. Estimated taxes are an advance payment of your expected tax liability and are due on a quarterly basis. Failure to pay these taxes on time can result in underpayment penalties, which can be costly.
The Impact of Inflation on Underpayment Penalties for Estimated Taxes
In recent years, inflation has been on the rise, making the cost of living more expensive. Ongoing inflation has also had a significant impact on the cost of underpayment penalties for estimated taxes. The penalties are assessed at a rate equal to the federal short-term interest rate plus 3%. As the Federal Reserve has continued to raise the targeted federal funds rate in an effort to control inflation, this has led to an increase in the federal short-term interest rate and, therefore, an increase in the penalty rate used to calculate the underpayment penalty.
In some cases, business owners may choose not to pay their quarterly estimated taxes because they believe they can earn a return on leaving that capital invested that outweighs the expected underpayment penalty amount they would incur for not making the payments. However, not paying quarterly estimated taxes can lead to significant underpayment penalties, which can quickly add up and eat into profits, especially as inflation is currently making the underpayment penalties more expensive. Additionally, any underpayment penalties paid are not deductible for tax purposes. It might make more sense to borrow from the bank to make the quarterly estimated tax payments since taxpayers are generally able to deduct the interest paid to the bank.
Our Advice? Avoid the Penalties Altogether
To sum it up, the effects of ongoing inflation have made underpayment penalties for estimated taxes more expensive. To avoid these penalties, it is important to keep track of your estimated tax payments and ensure that they are paid on time. If you have any questions about estimated taxes or underpayment penalties, reach out to your team at MGA for guidance.
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