IRS penalty for underpaying estimated taxes jumps to 8% of the shortfall from 3% two years ago - with freelancers and the self-employed most at risk

The IRS penalty for underpayment of estimated taxes is up sharply this year, with self-employed and freelance workers at the biggest risk of getting hit.

The penalty, calculated quarterly based on the Federal Reserve's benchmark rate, hit 8 percent on October 1, up from just 3 percent in early 2021, when Fed rates were near zero.

The penalty rate applies to shortfalls in estimated taxes, which self-employed workers pay the IRS quarterly based on their earnings for the period.

Employees who have income taxes deducted from their paychecks generally do not have to pay estimated taxes, and are unlikely to be impacted by the new fine.

But for the self-employed, the new higher fine is yet another consequence of the Fed's aggressive rate hikes, which the central bank has deployed to battle inflation.

The IRS calculates the underpayment penalty by taking the Fed's benchmark rate for the quarter and adding 3 percent. 

According to the Wall Street Journal, the IRS assessed more than $1.8 billion in penalties for underpaying estimated taxes on nearly 12.2 million individual returns in fiscal year 2022.

The IRS expects workers to pay taxes as they go, whether through paycheck withholding for employees or quarterly payments for self-employed workers.

Those rules apply to the period in question — meaning that if you underpay estimated taxes for a single quarter, you could still be penalized even if you pay more than is owed for the entire year. 

According to the IRS, you can avoid an underpayment penalty fine if your filed tax return shows you owe less than $1,000.

As well, anyone who pays at least 90 percent of what they owe for the tax year in question, or 100 percent of what they owed the prior year, is granted safe harbor from the fines.  

Not every freelancer has to pay estimated taxes. 

Generally, if you pay federal withholding through an employer, and have a small freelance 'side hustle,' you will not be required to pay estimated taxes each quarter.

The deadline to pay estimated taxes for the final quarter of 2023 is January 15, however, if you file your 2023 tax return by January 31 and pay all taxes you owe for the year, that deadline does not apply.

Estimated taxes can be payed through the IRS website at IRS.gov.