How Is Underpayment Interest Calculated?
Do you have unpaid federal taxes? If the answer is yes, you may be in jeopardy of paying interest on the unpaid balance if you can not pay your entire bill by the due date. Annually, the April 15th due date is applicable to most people filing their personal income tax returns (more on when taxes are due - here). Even if you file for an extension, paperwork must be filed by April 15th. Keep in mind that requesting an extension gives you an additional six months to file your return, not to pay any taxes that you owe.
Underpayment fees are separated into interest and penalties. These are calculated and assessed separate from one another.
The way that the IRS calculates interest is more straightforward than the way penalties are calculated. Starting with the rate itself, the IRS publishes underpayment interest rates every quarter (every three months) on their website. It is the federal short-term interest rate with 3% tacked on, and it is compounded daily similar to credit card interest. For example, the underpayment interest rate for the second quarter of 2017 is 4.04%.
Next, it is important to look at the length of time your taxes have gone unpaid. The underpayment period starts at the tax return's due date and goes until the date of payment, not the date that you receive a notice from the IRS stating that you have unpaid taxes or you realize you still owe money. Also, note, interest will continue to compound until the underpayment balance has been completely paid in full.
There are two types of underpayment penalties that are separate from the interest rate calculation: failure to file and failure to pay. Failure to pay penalties are typically 0.5% of the unpaid balance per month. The IRS will abate the underpayment penalty in some situations, such as having health problems or financial hardships that prevented you from paying your tax bill in full by the due date. However, you will still have to pay interest.
If you fail to file a tax return at all, the penalty is much steeper. You will be assessed 5% of the balance due for each full or partial month that your return is late for up to five months (25% maximum). If you are 60 days past the initial or extension deadline, the minimum late filing penalty is the smaller of $100 or 100% of your balance due. This is why it is so critical to always file an extension when you cannot file your return on-time.
If you are unable to pay your tax debt, the IRS may be willing to accept monthly payments via a payment plan/installment agreement. It is important to understand that you will still owe interest if you decide to work on a payment plan. If you are making payments on an installment agreement or payment plan, interest will still accrue on your unpaid balance until it is paid off in full. While the IRS may waive penalties, they rarely waive interest.
If you suspect that you can't pay your tax bill in full by the due date, you should still file your return and pay what you can to minimize your interest expense and avoid failure to file penalties.