If you owe $1,000 or more in tax when you file your 2005 return -- and the amount is more than 10% of your total tax bill for the year -- the IRS will assume that you also owe a penalty for failing to pay enough tax during the year via withholding or quarterly estimated tax payments. The penalty is the IRS's not-so-subtle reminder that taxes are due as income is earned, not in April of the following year.
The penalty works a lot like interest on a loan. The rate is currently 7%.
But before you pay the penalty, see if you can fit into one of the exceptions that protects you from it.
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- If you paid in at least 90% of your actual tax bill for 2005 (and any required estimated payments were made on time), for example, the penalty doesn't apply.
- If your payments during 2005 equaled the amount of your 2004 tax bill, forget the penalty -- no matter how much extra you owe when you file. However, as with so many tax rules, there is an exception to the neat 100%-of-last-year's-tax exception. If your 2005 adjusted gross income was more than $150,000, you had to pay in at least 110% of your 2004 tax liability to avoid the underpayment penalty.
Bottom line: Before you pay an underpayment penalty, check the rules carefully for a way around it.
And, even if you owe the penalty, don't worry about tackling the complicated Form 2210 to figure out how much you owe. The IRS will be happy to crunch the numbers for you -- you can double-check the bill when you get it. Letting the agency do that will allow you to hold on to your money for a bit longer. The interest clock stops running as soon as you pay your tax bill with your return; there's no interest charged on the penalty amount if you pay it by the date set on the bill.
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