RTS #034 What does the IRS’s 8% interest rate really mean?

You may have seen that the IRS recently increased the rate of interest they use to 8%. We’ve gotten a lot of questions from Advisors and taxpayers about what that really means, so let’s tackle it.

The first thing to know is that adjusting the interest rate is a normal activity for the IRS. They actually evaluate and can make changes on a quarterly basis (and often do). There wasn’t a new tax law change that prompted this recent increase; it just got a lot of attention because it’s the highest it’s been in years. For the tax nerds like me out there, you can actually see the IRS’s rates by quarter for the last several years on their website (in Q1 of 2021, it was down to 3%).

The IRS employs at least one clever copywriter because all of the information you find on the IRS website leads with the fact that the 8% is what they will use to calculate interest on overpayments made to the IRS by taxpayers. This might seem like cause for celebration, “the IRS is going to start paying interest in refunds!” BUT that’s not how the IRS plays the game. The IRS will, in fact, pay interest but in very limited circumstances and not at all in the same way it charges interest. The IRS only pays interest to taxpayers on overpayments (refunds) that are delayed more than 45 days from the returns filing due date. Which means most refunds are still, in fact an interest-free loan to the government.

The 8% much more often comes into play on what the IRS charges taxpayers for underpayments. And the IRS charges interest by a completely different set of rules. The IRS expects that you pay taxes throughout the year and will calculate underpayments by quarter and then charge interest accordingly (this is why withholdings are so powerful, they are treated as having been received throughout the year, even if they are paid on December 31st). Once an underpayment is calculated, the 8% is the annual rate used, and the calculation is done using daily compounding. Compared to just a few years ago, that means underpayments are a lot more expensive now.

Interest is completely separate from penalties, and they are not mutually exclusive. Most commonly, individual taxpayers are charged penalties for failure to file, failure to pay, and for significant underpayments. In those situations, there can be a 20% penalty on top of interest, and of course, the penalty itself accrues interest as well. It’s important to note that by law, the IRS has to collect interest, but there are situations where the penalties can be waived. For clients who owe the IRS large sums, focus on getting penalties waived, leave interest out of it.

The best approach, of course, is to avoid penalties and interest altogether. Pay particular attention to years with big life events (like retirement) or big swings in income (like one-time sales of assets, severance pay, equity awards, etc.). This is an area that should be part of your annual review of a client’s tax return and something you proactively help with throughout the year. Most tax pros are glued to the rearview mirror and might be too late to help your clients avoid interest.

What can you do about it?
Help your clients find ways to skew their tax payments towards withholdings over estimated payments. Social security is a great way to increase withholdings for retired taxpayers (use form W-4V). Also make sure as you do planning with clients that creates taxable income (Roth conversions, capital gains harvesting, investment income) you are helping them with a plan to pay the taxes as well. Especially for planning that happens late in the year (i.e. Q4 Roth conversions), make sure you are communicating to the client’s tax professional the timing of that income. The IRS assumes that income is earned evenly throughout the year UNLESS you tell them otherwise. We have saved taxpayers thousands of dollars of interest by proactively letting the IRS know that a large portion of their income for the year was in Q4.

Happy Tax Planning!

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The tax code is 80,000+ pages and Google has 875,000,000 results when you search “Tax Planning”, so each week we are going to help you wade through all of that noise and get to the Relevant Tax Stuff.