Estimated Taxes and the Safe Harbor Rule

Minimizing your income tax bill is an important part of your financial plan.

Many physicians 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 owed.

These numbers can be quite different.

What You Need to Know About Estimated Taxes and the Safe Harbor Rule

Taxes Withheld Do Not Equal Taxes Owed

I always get a kick out of people 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 their own money to the government 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 their Form W-4. An independent contractor or a partner does this by paying an appropriate amount with their 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.

Quarterly Estimated Payments

Since no one is withholding your taxes anymore, you are responsible for paying 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 postmarked by April 15 (of the current year), June 15, September 15, and January 15. 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 for 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 $1,000 total for the year (fat chance of that), have 100%-110% (the requirement is higher if you have more than $150,000 of income) of what you owed the previous year already withheld before transitioning from employee to independent contractor, or already have 90% of what you owe for the current year withheld.

I came very close to this situation in 2012 (my first time making estimated tax payments), so I know it is quite possible for a doc.

More information here:

What Happens If You Miss a Quarterly Estimated Tax Payment?

The 3 Big Tax Mistakes

There are three big mistakes to avoid when paying taxes.

#1 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).

#2 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).

#3 The third, and most serious mistake that commonly gets people into tax trouble with the IRS is to spend your tax money on something besides taxes, so that when April 15 comes around, you don't actually have the money to pay the taxes.

Understanding the safe harbor rules will help you avoid the first two problems. Understanding the tax code and being disciplined will help with the last.

Safe Harbor Rules

The tax system is a pay-as-you-go system. You can't just wait until April 15 and pay your tax bill. If you do, you'll owe penalties (0.25%-1% of the amount owed for each month it is owed) and interest (at the rate of the federal short-term rate—currently in the 4% neighborhood). But you can make a big payment on April 15 without paying penalties or interest IF you qualify under one of the following safe harbor rules.

1. You didn't owe any tax at all last year. (Good luck with this one.)
2. You underpaid by less than $1,000. (Basically, you never want to pay that last $1,000 you owe early.)
3. 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 before April 15.)
4. You paid in, either through withholding or via estimated tax payments, at least 100% (110% if you made over $150,000) of what you owed last year. (More on this below.)

You could also avoid the penalties (but not the interest) if your underpayment was due to disaster, casualty, other unforeseen circumstances, disability, or even retirement—if you can show the underpayment was due to reasonable cause and not willful neglect.

More information here:

How to Pay Estimated Taxes on a Roth Conversion

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. Rule 4 is really the only safe harbor that most physicians can actually count on. Take what you owed last year, multiply 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 15 and January 15.

Unequal Payments

So, you're thinking to yourself, why not just send in all the money on January 15? 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/prepaid may have little to do with the taxes actually owed, and come April 15, you've got to square the accounts.

Do you pay estimated quarterly taxes? If so, did you find it painful to figure out how much you owe? If not, how much have you paid in penalties and fees?

[This updated post was originally published in 2012.]