By Dr. Jim Dahle, WCI Founder
The IRS forces taxpayers to pay penalties and interest all the time. Most commonly, a taxpayer may have to pay an underpayment penalty, which basically just amounts to interest. It is just 0.5% of the unpaid amount per month to a maximum of 25%. Some savvy leveraged investors have realized that 6% a year is actually a pretty good rate for borrowing money, and they deliberately underpay their taxes because they expect to make more on the money than that penalty.
However, there are some penalties you really do not want when it comes to the IRS. Let’s go over the top five worst tax penalties.
#1 Tax Evasion
Tax evasion isn’t just a math error. It isn’t just being a little bit negligent about keeping receipts. It’s not even tax avoidance, where you deliberately live your life and pay your taxes legally to minimize your tax bill. Tax evasion is deliberately cheating on your taxes. It comes with a fraud penalty of 75% of the tax due up to $100,000 for individuals and $500,000 for businesses (plus the actual tax due plus interest). Perhaps most importantly, it can also come with jail time (up to five years). The only nice thing about having the government come after you for tax evasion instead of negligence is that you’re now in the criminal system (rather than Tax Court), where you are innocent until proven guilty. That’s not actually the case with most tax audits and disputes, including Tax Court cases. You actually have to prove your innocence in those.
More information here:
The 1 (Weird) Tax Trick the IRS Hates
Tax Avoidance vs. Tax Evasion — What’s the Difference?
#2 Failure to File
Which is worse: filing a false return or not filing at all? Hard to say, but they’re both bad. The penalty for failure to file is 5% of the unpaid taxes per month up to a total of 25%. If you’re expecting a tax refund, I guess it’s no big deal to file late. You’re just missing out on the use of that money for as long as it takes you to do your taxes. After five months, the failure to pay the penalty (0.5% per month) takes over since you’ve maxed out the failure to file penalty until it hits 25%. Interest starts accumulating on those penalties after a while, too.
#3 Inaccuracy Penalty
If you are grossly inaccurate when estimating things on your taxes, an auditor can assess a 20% of tax due “inaccuracy penalty” (plus interest). Examples of what can get you this penalty are intentional disregard of IRS rules, a substantial valuation misstatement, or a major understatement of income tax due. This is for when the IRS thinks it was more than an innocent mistake but less than real tax evasion. If the IRS doesn’t think it can win a case for tax evasion, it may simply assess this penalty since the standard to “convict” is so much lower.
#4 Failure to File Form 5500-EZ
One big surprise that some white coat investors with solo 401(k)s have run into is the penalty for filing Form 5500-EZ late. Once you have at least $250,000 in a 401(k), Form 5500-EZ must be filed each year. It’s no big deal to file (and there is no tax to pay with it; it’s just an informational return), but the penalty seems way out of proportion with the violation. The penalty is $250 per day to a maximum of $150,000. In case the math eludes you, it only takes 600 days to hit the maximum penalty. That’s less than two years. If you have made this mistake, you can beg for mercy. Often, you will get it, but there is no guarantee—and it can be a big hit on your retirement savings.
More information here:
Unhappy with Your Tax Audit Results? How to Appeal and Litigate an IRS Tax Audit
3 Big Tax Deductions for Doctors
#5 Failure to Take a Required Minimum Distribution
Another particularly egregious penalty occurs when one fails to take a Required Minimum Distribution from a traditional IRA or 401(k). This is becoming easier and easier to do all the time with the changing ages when one must first start taking them. Plus, we’re counting on seniors to take care of this, and their mental faculty generally declines over time. The penalty used to be a ridiculous 50% of the amount that was supposed to be withdrawn as an RMD (plus interest). However, thanks to the Secure Act 2.0, that penalty is now only 25% of the untaken RMD. Still, that’s a massive penalty for missing a withdrawal by one day. Like all penalties, interest can accrue on it too. Imagine if senile Grandpa forgets to take an RMD for two or three years in a row while in a nursing home. It could really do a number on an inheritance.
All of these tax penalties are best avoided by the savvy white coat investor. While I think you should pay every dime you owe in taxes, I don’t think you should leave a tip. These penalties would make a pretty huge tip.
If you need help with tax preparation or you’re looking for tips on the best tax strategies, hire a WCI-vetted professional to help you figure it out.
What do you think? What did I miss? What other outsized tax penalties are there? Comment below!
