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?
Thanks for a great article! This is very helpful. Things like this are essentially “traps” the IRS seems to set for people (at least some of these are) and I really appreciate you helping us avoid these mistakes. Thank you!
The penalty for filing form 5500 late is ridiculous, especially for solo 401k participants.
I had never even HEARD about the need to file form 5500-EZ at all! Previously I had had a 403b, but my institution transitioned to a 401k with Fidelity in 2023. Thank God I passed the tax documents I had received from Fidelity (documents I had never received before from any of the prior 403b providers, and which I didn’t understand why I was receiving) on to my CPA to figure out. This is one stupid penalty! A single one-time fine of $250, along with some education of the errant taxpayer, ought to be more than adequate given that no actual tax is owed.
If it’s not a solo 401(k), the institution ought to take care of it.
Here’s #6 – late filing of partnership returns: $220 for each month or part of a month (for a maximum of 12 months) the failure continues, multiplied by the total number of persons who were partners in the partnership during any part of the partnership’s tax year for which the return is due. If you have several partners, this is a pretty onerous penalty for a return that is for reporting purposes only. This penalty is fairly new and has caught many of us off guard. Fortunately, the IRS almost always gives you a pass the first time if you’re in good standing (client, I mean) but you must go through all the groveling snail-mail explanations and requests. Very important to do this for any 1st time penalty and I believe would have been a helpful add-on to the article, but I realize that was not the purpose of the article,
Oh good one. That’s a nasty penalty too. In general the penalties on business returns are worse than the ones on personal returns I’ve found.
Great info, thanks! Brutal penalties for lack of RMD withdrawl and the 5500EZ!
I also recently came across this article https://lawrina.org/guides/personal/estate-planning/probate/ , and it was surprising to me that the assets of the deceased are paid off by the estate, and the rest is distributed to the beneficiaries. However, the inheritance law does not apply to assets transferred to a trust, in accounts with beneficiaries or in joint ownership. This is because in such circumstances the assets automatically pass to the named beneficiaries.It seems very strange also
Thank you for the great info regarding needing to file the 5500EZ. I’m with Schwab and they haven’t notified me of the need to do this.
In filling out form 5500EZ I have a question. My wife worked as a realtor under a broker in a real estate firm. Although she is technically self employed, she gets paid sales commissions from the broker out of sales proceeds. On form 5500EZ, I assume that the broker/real estate firm should be listed as the employer. Who should be listed as the plan administrator? If she should be listed as the plan administrator, does she need to obtain an EIN?
Thanks for any assistance you can provide. No one at Schwab is able to help me fill out this form and my CPA is unfamiliar with it!
If it is a solo 401(k), SHE is the employer and her business should be listed. She is likely the plan administrator too. Yes, most solo 401(k)s require an EIN
Thanks Jim. Your blog with the information on this topic is VERY helpful and much appreciated!
My wife got a letter from the IRS with a $80,000 fine for not filing a 5500 which was now a year over due.
The crazy thing was that we did submit it. We did it on-line but put the wrong date (used the year we filled it out not the prior year) in the form.
We learned that if there is a mistake they will not notify you. The site accepts your submission and says in process. It is your responsibility to ensure it was accepted by going back to the site and checking that it was accepted.
We begged and were given forgiveness.
Now we file the first week of January and check to make sure it is okay every month until July.