By Dr. Joshua White, PGY-2 in Emergency Medicine, and Dr. Michael Brodeur, Assistant Clinical Professor at the CHRISTUS Health/Texas A&M Emergency Medicine Residency Program, Guest Writers
As a resident new to moonlighting as an independent contractor, I am amazed at how much changes financially when you both have a significant alteration in income and become an independent contractor. This post is intended to help all those who are undergoing this process to know what to do and how to prepare.
Taxes really increase in complexity when you obtain some of your yearly income as an independent contractor. Before this transition, taxes were simple for me. Taxes were taken out of my paycheck every pay period based on my estimated tax rate (automatic withholding), and I didn’t think much of it. However, as your income increases, personal knowledge of taxes is crucial to your financial success. Here are four simple tax rules to ensure success:
#1 Save Enough to Pay the Taxes Owed to the IRS
As overall income increases that includes income as an independent contractor, taxes owed significantly increase. It is essential to set enough of your income aside to pay the taxes that you owe when the IRS comes calling. If not, you will be subject to penalties, interest, and of course, the taxes. But how do you know how much money to save each year?
Total taxes owed = Federal income tax + State income tax + FICA taxes (Social security + Medicare)
Federal Income Tax
Marginal vs Effective Federal Tax Rates
In the United States, we have a progressive federal tax rate meaning that the more money you make, the more your average tax will be. To understand the tax code, it is important to understand the difference between marginal and effective tax rates. Your marginal tax rate is the highest bracket some of your money falls into. For instance, if you have $100K of taxable income in 2021 and you file “Single”, the highest tax bracket some of your money falls into is 24% based on the current tax rate range. However, your average tax rate is much lower. Some of your money will get taxed at a 22%, 12%, and 10%. Your average tax rate is your effective tax rate. In this example, the marginal federal tax rate is 24%, and the effective federal tax rate we will calculate below.
How to Calculate Your Effective Federal Tax Rate
Your Effective Federal Tax Rate= Total Taxable Income/Total Federal Taxes Paid
Calculate your estimated effective tax rate by using the amount of your projected gross income that falls into each tax bracket and multiply it by each respective tax rate, and then add it all together. This will equal the total taxes owed and using the above formula you can then calculate your effective tax rate.
For example, if you have a projected gross taxable income of $100,000, and plan to file single, the formula would look like this:
Total taxes owed= (9,950 x 0.1)+((40,525-9,950) x 0.12)+((86,375-40,525) x 0.22)+((100,000-86,375) x 0.24)= $17,748.50.
Now calculate with your taxable gross income = $17,748.50/$100,000 = 17.748%. This is the effective federal tax rate for this individual.
FICA Taxes: Medicare + Social Security Tax
How much FICA tax owed will depend on if you are an employee and receive a W-2, or an individual contractor and receive a 1099, or both.
- Social security tax is 6.2% for the employer and 6.2% for the employee. Social security tax stops on any additional income above a certain amount “wage base” each year. In 2021, the wage base is $142,800.
- Medicare tax is 1.45% for the employer and 1.45% for the employee.
- Additionally, after $200,000 of taxable income there is an additional 0.9% tax that the employer pays.
In application, if you are an employee, you will owe 7.65% of your taxable income until you reach $142,800. Every taxable dollar above that amount you will only owe 1.45% of your income to Medicare taxes.
However, if you are an independent contractor, you are responsible for paying both the employee and the employer portions. So you will owe 15.3% of your taxable income until $142,800 and then 2.9% for each taxable dollar from $142,801 until $200,000, and then 3.7% of your taxable income to FICA taxes for anything above $200,000.
State Income Tax
State income tax varies widely from state to state.
How Much Should You Plan for Taxes When Moonlighting as a Resident?
The calculation gets more complicated if you are both an employee and produce income as an independent contractor. It is important to factor in the employee income first before adding in the self-employed income (this means that the employer will pay for their portion of your FICA taxes first).
For illustration, here is a graph of your effective tax rate based on your income. This includes FICA taxes, but does not include state taxes. It also assumes $60,000 in income from an employer, and any interest obtained as an independent contractor (very comparable to a resident’s financial situation).
Compare that to a graph for all income obtained as an independent contractor:
In summary, calculating taxes owed is complicated, but the important part is saving enough to pay taxes at a later date. In my scenario, since there are no state income taxes, I plan to put aside for taxes 25-30% of the extra income generated Moonlighting (in addition to the taxes owed on my employee salary as a resident).
#2 Remain in Safe Harbor
To say in safe harbor, pay the IRS the taxes they require at the appropriate time and in the appropriate amount.
What to Pay for Quarterly Payments
When you obtain income from being an independent contractor, the IRS requires that you pay quarterly payments throughout the year. These should be equal payments based on your earned income. The goal is not to pay all the taxes that you owe in the four payments, but to avoid fees from the IRS without grossly overpaying—as that gives the government an interest-free loan.
There are several rules to stay in safe harbor (to avoid fees from the IRS), but the safest and easiest one is the 100%/110% rule. If you pay 100% of what you owed last year in 4 equal payments during the current tax year and you make under $150,000, you are in safe harbor. If you make over $150,000, that percentage increases to 110%.
When to Pay Quarterly Payments
For the tax year 2021, estimated tax payments are due on the following dates as follows:
- April 15, 2021 (for January 1-March 31)
- June 15, 2021 (for April 1 to May 31)
- September 15, 2021 (June 1 to August 31)
- January 15, 2022 (September-December 31)
- In addition to these estimated payments, the deadline to file your taxes is April 15th of the following year.
These dates typically stay the same from year to year. You will make 4 equal payments if you work the whole year as an independent contractor. If your work as an independent contractor starts on July 1st, the White Coat Investor suggests that you pay your estimated taxes in 2 payments: one on September 15, and one on January 15th.
How to Pay Quarterly Payments
You can pay electronically through this website, by phone, or by mail if you send a check with Form 1040-ES. You can also pay with your mobile device using the IRS2Go app.
Where Do You Put Your Money Before the Tax Due Date
Put your money somewhere safe where you can easily withdraw it at the time of the tax due date. Do not put it in a high-risk investment portfolio, as this money needs to be guaranteed. I would recommend a high yield savings account.
#3 Maximize Tax Deductions and Credits
As an independent contractor, taxes owed are accounted with these forms:
- Each independent contractor is self-employed, and when they start doing work for each client, they will fill out a W-9 (equivalent to an Employers's W-4).
- In return, each client the independent contractor worked for during the tax year will send them a 1099 form (equivalent to an Employers's W-2).
- If you are a sole proprietor (which is the default business structure), then these 1099 forms will flow on to Schedule C, and then on to a 1040 when you file your taxes.
When you file your taxes, the goal is to claim all the credits and deductions that are available to you so you owe less taxes. The government gives you discounts on taxes through deductions and credits. A deduction will reduce your taxable income, so it reduces the amount of money you pay taxes on. A credit directly reduces the amount of taxes you owe dollar for dollar.
When you file your taxes, you will have the option of choosing standard or itemized deductions. In 2021, the standard deduction is $12,550 for singles and $25,100 for married couples. Meaning if you choose the standard deduction and file single, you will have $12,550 less income to pay taxes on. Only choose itemized deductions if you have more deductions to deduct than the standard deduction. Itemized deductions = below the line deductions. Examples of itemized deductions include: charitable donations, medical expenses, home mortgage interest, and others. Above the line deductions are deductions that can be taken in addition to the standard deduction. Which is wonderful! Here are some notable above the line deductions to take advantage of:
Tax-Deferred Retirement Plans
Because you have some income from your self employment, you have a couple of retirement plan options available to you that are not available to those who are just employees. You can choose either a SEP IRA or a Solo 401(k) to contribute to. There are pros and cons discussed by the WCI but overall he recommends the Solo 401(k). This isn't a pure deduction as it defers taxes until a later time (usually retirement when your tax rates will be lower), but it does reduce the income you will pay taxes on during that tax year in addition to helping you save money for retirement.
Limits: the most you can contribute to a 401(k) as an employee across all employers is $19,500/year. However, if you are an independent contractor, you can also contribute as the employer up to 20% of your net income with a limit of $58,000 in 2021.
In 2021, you can contribute up to $3,600 if single and up to $7,200 if married to an HSA plan. This is deducted from your taxable income, but is not taxed when you withdraw from it to pay for health related expenses. However, in order to qualify you have to have a high deductible health plan, and you can’t have access to a group policy coverage.
Remember those self employment taxes that are owed? Half of those self-employment taxes paid can be deducted from your taxable income.
Up to $2500 in student loan interest can be deducted each year if your income is below a certain limit. If you file single this benefit starts to phase out at $70,000 and ends after $85,000 in adjusted gross income. For married couples, the phase out runs from $140,000-170,000. One resident I know wasn't aware of these limits and was aggressively paying off student loan interest with moonlighting income fully expecting it to be deductible. It wasn’t!
Any expenses you pay for your business you can deduct from your adjusted gross income. Keep track of what you spend on mileage, scrubs, equipment, licensing fees, etc., and it can help you on tax day.
#4 Increase Your Personal Tax Education
The final tool to increase tax success is to be informed on tax law and how it affects you. I recently read the book Taxes Made Simple by Mike Piper, which was recommended by the White Coat Investor, and I highly recommend it. It was easy to understand, covered the basics of taxes, and I think it should be a must-read for everyone.
Have you moonlighted? What other steps have you taken to ensure you pay the taxes you owe without leaving a tip? Comment below!
[Editor's Note: This article was submitted and approved according to our Guest Post Policy. We have no financial relationship.]