In this post, you will learn everything you wanted to know about estimated taxes. Note that this applies not only to physicians and other high-income professionals, but also to self-employed individuals from all points of life. I’m looking at you, bloggers and entrepreneurs.
As always, this classic article first appeared on The White Coat Investor.
Estimated Taxes and the Safe Harbor Rule
Minimizing your income tax bill is an important part of your financial plan. Many physicians either coming out of residency or moving from an employed position to one as an independent contractor or partner aren’t aware of the need to pay quarterly estimated taxes. Even worse, many doctors don’t realize the difference between the amount of taxes that are withheld and the amount that are owed. These numbers can be quite different.
Taxes Withheld Do Not Equal Taxes Owed
I always get a kick out of people who are excited to get a big tax refund. “Tax refund sales” pander to the financial ignorance of our nation. These fools rejoice in the fact that they got to loan the government their own money interest-free for a period of up to 16 months! Instead, your goal ought to be to pay as few of your taxes as possible until the last possible moment without owing any penalties or interest.
An employee does this by selecting an appropriate number of allowances on his Form W-4. An independent contractor or a partner does this by paying an appropriate amount with his quarterly estimated tax payments. But either way, the amount withheld or sent in with estimated tax payments may have little to do with the actual amount of taxes owed at the end of the year.
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Quarterly Estimated Payments
Since no one is withholding your taxes anymore, you are responsible to pay them yourself. This includes your federal income taxes, your payroll taxes (Social Security and Medicare), your state income taxes, and if incorporated, your state and federal unemployment insurance payments.
These quarterly payments must be post-marked by April 15th (of the current year), June 15th, September 15th, and January 15th. State deadlines often differ slightly and the payments are sent to the state tax commission instead of the US Treasury/IRS, but the principle is the same. Instructions for how to do this can be found on IRS Form 1040-ES.
There are a few exceptions to the need to make payments, but most doctors don’t meet them, except possibly in their first year as an independent contractor/partner. To avoid making quarterly estimated tax payments, you need to either owe less than $1000 total for the year (fat chance of that), have had 100%-110% (requirement is higher if you have more than $150K of income) of what you owed the previous year already withheld prior to transitioning from employee to independent contractor, or have already had 90% of what you owe for the current year withheld.
I came very close to this situation in 2012 (my first making estimated tax payments) so I know it is quite possible for a doc.
The Three Big Tax Mistakes
There are three big mistakes to avoid when paying taxes.
The first, least serious mistake, is to pay your taxes earlier than you have to (or pay more than you owe in the first place.
The second, more serious mistake, is to not pre-pay a high enough percentage of your taxes and thus owe penalties and interest (not to mention the taxes themselves.)
Safe Harbor Rules
The tax system is a pay-as-you-go system. You can’t just wait until April 15th and pay your tax bill. If you do you’ll owe penalties (1/4 to 1% of the amount owed for each month it is owed) and interest (at the rate of the federal short-term rate– as of September, 2017 around 1.3%- plus 3%). But you can make a big payment on April 15th without paying penalties or interest IF you qualify under one of the following safe harbor rules.
- You didn’t owe any tax at all last year. (Good luck with this one.)
- You underpaid by less than $1000. (So basically you never want to pay that last $1000 you owe early.)
- You underpaid by less than 10% of what you owe this year. (Again, no point in ever paying more than 90% of your tax bill prior to April 15th.)
- You paid in, either through witholding or via estimated tax payments, at least 100% (110% if you made over $150K) of what you owed last year. (More on this below.)
You may also be able to avoid the penalties (but not the interest) if your underpayment was due to disaster, casualty, other unforeseen circumstance, disability or even retirement, if you can show the underpayment was due to reasonable cause and not willful neglect.
The 110% Rule
Estimating your taxes isn’t necessarily easy, especially when you have a variable income like most physician independent contractors or partners. Doctors rarely qualify under rule 1, and rules 2 and 3 require you to somewhat accurately estimate your current tax bill. So rule 4 is really the only safe harbor that most physicians can actually count on. To be safe, take what you owed last year, multiple it by 1.1, then divide it by four, and send in a check for that amount every quarter.
If you transitioned from an employee position midway through the year (like most docs), it can be even trickier. You take what has been withheld so far for you, subtract that from the amount owed last year multiplied by 1.1, divide by two, and send that amount in on September 15th and January 15th.
So, you’re thinking to yourself, why not just send in all the money on January 15th? Unfortunately, the IRS is one step ahead of you. Your payments throughout the year have to be related to your income throughout the year, as you can see on Form 2210. Interestingly, if you have the money withheld by an employer, it doesn’t matter when it was withheld. You can claim 50 allowances all year, then claim 0 in November and December, and if you otherwise fall into the safe harbor rules, no penalties or interest are owed!
Remember To Keep Your Tax Money Safe
If you pay less than you owe, either deliberately or accidentally, be sure to keep enough cash on hand to pay those taxes come April. Remember that taxes withheld/pre-paid may have little to do with the taxes actually owed, and come April 15th, you’ve got to square the accounts.
11 thoughts on “Estimated Taxes and the Safe Harbor Rule”
What about if you created a single member (S-Corp) LLC? You’re still technically employed, but self-employed at the same time? Do you still have to pay quarterly estimated taxes, or does your LLC payroll withholding cover this?
In same boat
I’m not sure what you mean by “still technically employed,” but it sounds like you are self-employed in that situation, and will have to pay quarterly estimated taxes.
To further clarify your situation, I would recommend posting a new thread on the WCI forum with more details on your employment / self-employment situation. Several CPAs and dozens if not hundreds of self-employed physicians are regular readers and responders.
Bear with me, but as I understand it, at the time I pay myself “reasonable” wages (since I can’t draw all the profit as a distribution), my LLC has to run payroll for me as its single employee, withholding federal and state taxes according to a W-4 declaration, and FICA contributions, and at the end of the tax year issue a W-2 for the totals paid via payroll. In this situation, I am an employee of my own LLC.
Employee payroll can happen on any frequency the LLC decides. If I make it monthly, the LLC is already withholding actual income taxes for me on a monthly basis, so presumably that means I (the self-employed person) should file a quarterly estimate of zero to avoid paying twice?
I assume that in this case is the quarterly estimate is only supposed to cover distributions (profit) I make to myself from the LLC that are not classified as W-2 wages? If this is the case these are virtually impossible to estimate, and I would end up filing quarterly estimates of zero in Apr, Jun and Sep, and paying myself a single distribution in Dec, reporting and paying that quarterly estimate in Jan. I don’t see how the IRS gets it’s quarterly payments any quicker unless you actually take distributions (not wages) periodically throughout the year. Am I missing something?
Thanks for forum link – I also posted the question there.
Good call. You’re getting better information for your specific situation than I could provice. Thread here for those following.
“To avoid making quarterly estimated tax payments, you need to either owe less than $1000 total for the year (fat chance of that).”
I don’t know man, I have a very easy time keeping my blog profits low enough to owe less than $1,000 in taxes. With proper recording of business expenses – or, you know, lack of revenue in the first place – it’s easy!
This is brilliant. My husband is responsible for doing quarterly taxes on my side earnings. Our situation can be described as messy. My husband withheld too much last year and we ended up with a 8000 tax refund which meant we overpaid. I was not happy.
It’s so hard to gauge and that 1.1 formula probably won’t work for us until at least next year. Still sharing this with hubby though 😉
What happens if you miss the deadline for a quarterly estimated tax payment? Does the payment just get counted for the next quarter? I actually just had this happen and missed the September deadline by a day.
It is a small penalty as I recall. I have done it once or twice. If you are just a day or two late I would just send in the payment.
I might add, having one spouse working in the corporate world and one self employed can make it more complicated. With the corporate world having bonus compensation held at different rates, like RSUs, it’s hard to determine where the full Time employee tax payments will land for the year. They could offset much of the self employed income, or not. It’s important to regularly monitor if you have self employed income.