Taxpayers have questions on IRS interest charges
A reader reached out with a question about interest the IRS charges on tax underpayments.
For the 2023 tax year, “Samuel” paid a larger estimated tax than was due to cover his tax obligation. But the year before, he underpaid, and as a result, he owes the government interest (a penalty) for the underpayment for the 2022 tax year.
Samuel's question really has to do with reciprocity and ultimately, fairness: “Will the IRS now pay us any interest on this overpayment? It seems only fair that if they can charge us interest or penalty on an underpayment, they should then pay us interest for using our overpayment for the year.”
In Samuel's case, an overpayment followed an underpayment.
According to an IRS spokesperson, this type of situation “is no different than a wage-earner who overpays their taxes through withholding and gets a refund as a result of filing their 2023 return.”
“Normally, a taxpayer won't receive interest on their refund, unless it takes a long time to process their return,” the spokesperson said, adding, “That happened a lot during the pandemic, and largely for that reason, the IRS had to pay interest on a relatively large number of refunds.”
There is a special provision for those who make estimated tax payments, according to the IRS spokesperson: “If you overpay your 2023 tax, instead of receiving a refund, you can choose to apply that overpayment to your 2024 estimated tax payments. If you file on time, your overpayment will count as an estimated tax payment made on April 15, 2024, regardless of when you would have received it, had you chosen that option.”
The basis for how taxes are paid and penalties levied goes back to the “pay as you go” nature of the tax system, which was set by Congress, not the IRS. The Current Tax Payment Act of 1943, passed during World War II, called for withholding taxes from paychecks and paying those taxes to the government (tinyurl.com/38kk2c68).
As the IRS explains on its webpage “Pay As You Go, So You Won't Owe” (tinyurl.com/ vzjy8fk2):
“This means that you need to pay most of your tax during the year, as you receive income, rather than paying at the end of the year. There are two ways to pay tax:
• “Withholding from your pay, your pension or certain government payments, such as Social Security.
• “Making quarterly estimated tax payments during the year.
“This will help you avoid a surprise tax bill when you file your return. You can also avoid interest or a penalty for paying too little tax during the year. Ordinarily, you can avoid this penalty by paying at least 90 percent of your tax during the year.”
According to the IRS spokesperson, the tax penalty “is designed to encourage people who either don't have withholding, or don't have enough withholding, to make these payments, make them timely and make them at sufficient levels.”
The IRS provides more details on its webpage “Underpayment of Estimated Tax by Individuals Penalty” (tinyurl.com/477e9y4s). Included is information on how the penalty is calculated, interest on the penalty (additional details on interest can be found at tinyurl.com/2b9nsuhn), and removing, reducing or disputing a penalty.
“Of course, as we all know, there are many practical problems with figuring and making estimated tax payments, but that's also why there are thresholds and exceptions in the law that are designed to ease the burden,” the IRS spokesperson said, adding that taxpayers “can, and often do, vary their estimated tax payments throughout the year to accommodate fluctuations in income.”
If you are new to paying estimated quarterly taxes, be sure to review the IRS webpage “Basics of estimated taxes for individuals” (tinyurl.com/3w9ekftz) and IRS Publication 505, “Tax Withholding and Estimated Tax” (tinyurl.com/3mwahezp). Also, if you live in a state that has a state income tax, you will want to review the state's instructions related to who is required to make estimated tax payments.
Seasoned investment counsel (tinyurl.com/52nus8hz) and awardwinning columnist and author, Julie Jason, JD, LLM, promotes financial literacy and investor protection. Read her latest book, “The Discerning Investor: Personal Portfolio Management in Retirement for Lawyers (and Their Clients)" (tinyurl.com/4u7h9pjs), published by the American Bar Association. Write to Julie at readers@juliejason.com. While all questions cannot be answered, each email is read and reviewed and can lead to discussion in a future column.