By Dr. James M. Dahle, WCI Founder
Many doctors hired as independent contractors do not understand their obligations to the IRS. As an employee, your employer withholds taxes from your pay and sends that tax money to the IRS. They may withhold more than you owe or less than you owe, but you simply settle up when filing your taxes the next April.
If you had too much withheld, you get a refund. If not enough was withheld, you send in a check with your taxes.
However, as an independent contractor, nobody is withholding taxes on your behalf. Four times a year, you are required to send an estimate for taxes due as a “Quarterly Estimated Payment” on IRS Form 1040-ES.
It's an easy form to fill out and file (you can even schedule payments in advance using EFTPS); you just have to remember to do it. These quarterly estimated taxes are due April 15, June 15, September 15, and January 15. Note that those dates are not all three months apart.
How much to pay? Well, that's complicated, but the bottom line is that you want to be in the “safe harbor.” Being in the safe harbor won't keep you from having to pay more tax in April, but it will avoid any penalties or interest. Most docs simply multiply their prior year's tax bill by 110%, divide by four, and send that amount to the IRS each quarter. That is not the only way to stay in the safe harbor, but it is the easiest way to calculate.
What Happens If You Miss a Quarterly Estimated Tax Payment?
Many new attendings are not aware of this requirement. I always tell all my new partners about this, and it's usually news to them. Many doctors do not get this news until it is too late. What happens to them?
Well, the IRS is not too happy. Theoretically, they end up having to pay the following amounts:
- All of the tax due
- Penalties (0.5% of tax due per month)
- Interest (currently 3% of unpaid tax per year)
The first one is actually the biggest problem. Many of those docs spent the money they should have paid in taxes on a fancy new Tesla. Depending on when they realize their mistake, they may have to dedicate their entire paycheck for several months to their tax bill or, worse, they end up carrying a debt to the IRS for years afterward.
However, most people agree that it is only fair that they pay the tax that they should have originally paid. They don't feel it is too fair to nail them for not knowing about this requirement that is only for business owners. Luckily for them, the IRS agrees. At least the first time.
Penalty Relief Due to First-Time Penalty Abatement
The IRS calls this a “first-time penalty abatement.” Here's the way it works.
First, remember it is optional. The IRS does not HAVE to offer you this.
Second, remember it really only works once and it has to be the first year you were supposed to file 1040-ESs and pay estimated quarterly taxes.
Third, if you qualify, you still have to pay the tax due, but the penalty and interest are likely to be waived.
How Do You Qualify?
All of the following must be true for you to qualify:
- You didn’t previously have to file a return or you have no penalties for the three tax years prior to the tax year in which you received a penalty.
- You filed all currently required returns or filed an extension of time to file.
- You have paid, or arranged to pay, any tax due.
Basically, you pay your taxes and then you plead for mercy to waive the penalties and interest. You are much more likely to receive that penalty abatement if you have actually paid the tax due. Simply call the toll-free number that comes with the notice about the penalties and interest and plead your case. If it's the first time, you'll probably get it. If the penalty is waived, the interest is also generally waived.
Can You Use Penalty Abatement Strategically?
Let's take this to the next level. Let's say you come out of residency on the first of July and will be an independent contractor. You expect to make $200,000 during the rest of the year and owe perhaps $60,000 on that money. What if you used the money you would have paid in taxes for July to December to pay off student loans, max out retirement accounts, or make a down payment on a house? Then, you could save up the tax bill you will owe in April of the next year between January and April. Then, you could plead for penalty abatement and, in essence, enjoy an interest-free loan from the IRS for nine or 10 months.
Be very careful with this technique. The IRS is considered a “super creditor.” You are far better off owing money to almost anybody else than to the IRS. You need to be very sure you will have the money come April 15. Also, check with your state. It may not offer you penalty abatement if it is a pay-as-you-go state. Some states, such as Utah, are not pay-as-you-go. They have no problem with you paying your entire year's tax bill on April 15. But you will be responsible to make sure you have the money to pay.
First-time penalty abatement is one of the few times that the IRS will give you a mulligan. Take advantage.
What do you think? Have you received a first-time penalty abatement? How did it work out? Comment below!
The IRS has a website that makes it easy to pay all Federal taxes, including 1040ES. It’s eftps.gov. (electronic federal tax paying system) California also has one, and others states may too. Many may be using it already, but if not, check it out.
quick correction to safe harbor paragraph; sb 110% of LYs TAX (not income)
Thanks for the correction. Absolutely true.
Totally agree. Makes the actual payment of the tax bill super easy. I’ve been using it off and on for years but now use it for pretty much every federal tax payment.
First year attending here. I just did a rollover of my pre-tax residency retirement plan to my Roth IRA, roughly 26k in total. Obviously I need to pay taxes on this money. Should I just make a one time estimated quarterly payment come April? The rest of my income for 2022 will be W2. Is the amount owed as simple as just multiplying my tax bracket by the amount converted? Appreciate the help!
Yes, it’s that simple. Do you have to make a one time quarterly payment? Maybe, maybe not. If you’re still in the safe harbor, you’re fine. If you’re not, then yes, you’ll need to make a quarterly payment. More info here on the safe harbor:
https://www.whitecoatinvestor.com/estimated-taxes-and-the-safe-harbor-rule/
It may be easier to divide the number of pay periods you have left in the year into to the $26K and have this amount added to your fed. tax deduction each pay period. And yes, multiply your tax bracket by the $26 K to get the tax due. But remember, the added amount may push you into a higher tax bracket so watch for that. If you’re not already enrolled in the EFTPS.gov. check it out (see my post above) They make it easy to do 1040ES.
Since you are considered self-employed as an independent contractor, is FICA tax for Social Security and Medicare also required to be included in estimated tax payments along with estimated Federal income taxes. Isn’t the FICA rate 15.3% [both employee and employer halves] to the income limit for current year, and continues above that limit at 2.9% for Medicare, again, both employee and employer halves?
Yes. That needs to be included.
Is one eligible for Penalty Abatement due to failure to make:
– All estimated tax payments
– One or more payments
– The correct amount of payments for one or more quarters
I think so.
I have wondered if the taxes due on our capital gains and dividend income (quarterly mutual fund distributions or passive real estate distributions) should be paid at these estimated quarterly due dates. Should we be paying those quarterly?
I elect to have extra income withheld from my W-2 paycheck to give me some buffer but I end up having more tax due at the end of the year so I have made an estimated tax payment in the 4th quarter to make sure I don’t owe…but is that necessary?
If you need to, it’s necessary. But in order to know for sure, you need to know your exact tax situation. More info here:
https://www.whitecoatinvestor.com/estimated-taxes-and-the-safe-harbor-rule/
Silly question from a W2 employee: I somehow owed like 2k for tax year 2020 even though I didn’t change my W4 and then my accountant suggested that I do quarterly estimated payments to avoid tax fees due to underwithholding in the future.
For tax year 2021 I just withheld a bunch more each paycheck and had a refund of 3k.
Do I have to do estimated quarterly payments? I don’t think I do and my accountant said I was fine not doing quarterly payments but I’m not sure.
No. Your current approach seems fine, so long as this year looks like last year.
First timer commenter; I am a senior resident and just began moonlighting externally. My standard salary and internal moonlighting already has taxes deducted, does this mean I will only estimate the taxes for my external moonlighting?
Yes. You might even just be able to increase how much is withheld from your regular paychecks and not pay any quarterly estimateds if you don’t make too much moonlighting.