Why More Workers and Retirees Are Paying Income Tax Penalties

couple doing taxes
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More people who must pay federal income taxes each quarter are also paying tax penalties, according to the Wall Street Journal.

Citing Internal Revenue Service data, the newspaper recently reported that the number of federal income tax filers who were penalized for underpaying their estimated quarterly taxes jumped by almost 40 percent between 2010 and 2015, reaching 10 million.

These filers include freelance workers, self-employed folks like business owners and folks who work side gigs. They also include retirees who receive distributions from their tax-sheltered retirement accounts.

Income earned by these filers, which often varies from month to month, is taxed differently than the paychecks of people who are employees of companies. Independent workers don’t have an employer automatically withholding taxes from their paycheck. So they must pay taxes to the IRS each quarter based on how much income they estimate they will earn.

IRS spokesperson Eric Smith tells WSJ:

“The data suggest that millions of people don’t understand they need to pay quarterly taxes, or at least increase their withholding to avoid penalties.”

Why more taxpayers are incurring penalties

The reasons for this trend “aren’t clear,” WSJ says. There are several possible explanations, though. They include that:

  • The interest rate the IRS charged on underpaid taxes from 2010 to 2015 was only 3 percent, the lowest in decades. Currently, the rate is 4 percent.
  • More baby boomers are retiring from full-time jobs or receiving distributions from retirement plans like traditional IRAs and 401(k)s as is required starting at age 70½. So they might not realize they owe quarterly tax payments on some or all of their income.
  • Gig work has become more common, with more people seeking to supplement their paycheck, if not make a living, through websites such as Airbnb. They too might not initially realize that they owe quarterly tax payments.

What independent workers should know about tax law

Freelancers, business owners and people with side gigs often already have more work-related expenses than employees of companies. If you are among them and you wish to retire comfortably one day, do not add tax penalties to those expenses when it can be avoided.

Educate yourself about what you must do differently as a taxpayer.

As our story “11 Keys to a Successful Freelance Career” notes:

“You’ll need a tax adviser experienced at working with freelancers. Even if you’re happy doing your own taxes, consider professional help the first year so you understand the requirements, get the right start with bookkeeping and have help weighing whether to incorporate.”

That article details how much income independent workers are expected to pay for federal income taxes, Social Security and Medicare.

For example, you’ll learn that as an employee of a company, your employer pays part of your Social Security and Medicare taxes. As an independent worker, you must pay it all.

What’s your take on this news? Sound off below or on our Facebook page.

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