[Editor's Note: The following guest post was submitted by a regular reader and emergency medicine physician who would like to remain anonymous. We have no financial relationship.]
TurboTax Grief
I clicked the “Continue” button in Turbotax and the numbers started turning. They went from green (refund) to gray and just kept going…and going. It finally settled on $8,000 in taxes owed to the IRS.
I went through the stages of grief in rapid succession, only settling on grief after a futile Google search to figure out how we could owe so much. I have been doing our taxes since the year we got married and we have never owed more than a few hundred dollars. Sometimes we got a refund. We certainly aren’t tax cheats and I thought we had our withholdings properly figured out for the year.
Warning: Don't Fall Into the Same Trap!
Fortunately, we have a large enough emergency fund to cover this unexpected expense but I am writing this as a warning to other physicians to not fall into the same trap that we did. The reason this happened is we now have a large difference in incomes. This is a not an uncommon situation for some physicians, especially if you and your spouse are in different years of training. Also, this post only applies when you and your spouse are both W-2 employees, not independent contractors.
Our Tax Problem
My wife and I moved in the summer of 2016. As of right now we don’t have any kids but we are expecting our first child soon. We have a two-year separation in training. Before we moved, I was working as an attending physician with the military while she was a chief resident in primary care. I made approximately $130K that year while she made approximately $115K. Her chief resident year was an attending position that paid close to what junior faculty at her institution were paid. So for the 2015 tax year and the first half of 2016, we had relatively similar incomes.
I left the military in the summer of 2016 and we moved so she could start a fellowship. This led to a significant raise for me to about $262K but her salary went down to about $60K. When we filed our 2016 taxes we received a refund of about $2K. Therefore, that difference in our income wasn’t a big deal in that first year since we moved in July and the difference in incomes was only present for 6 months.
Miscalculating W-4 Allowances
All was well until that fateful moment in January 2018 when I went to work on our taxes and gulped when I saw that $8K figure. I sat down with an accountant and it took him approximately 5 seconds to tell me that the problem was our large difference in income. We should have withheld a lot more since starting our new positions. We had both written on our W-4s that we were married and claimed 1 allowance each because this is what we had always done. I felt a little better when my accountant said that he has a few clients each year who fall into this trap.
Even though my wife and I work for the same employer, the payroll systems don’t talk with one another when it comes to being married to someone else inside (or outside) your organization. If we were not married, then our withholdings would be completely appropriate for our financial situation. However, with such large differences in income, the lower earner is not being taxed at a high enough rate. When their income is added on top of the higher earner, that income is in a much higher tax bracket with much higher taxes. To be clear, my wife’s income did not bump us up into a new tax bracket when added to mine. However, when my wife’s income was added to my income, her income is entirely taxed at a much higher rate.
Unfortunately, choosing the “married but filing separately” option does nothing to alleviate this. I “forced” TurboTax to do this and it resulted in an even higher tax bill. The reasons behind this are well beyond the scope of this post.
Married But Withholding at the Higher Single Rate
With the caveat that I am not a CPA (but as suggested by my CPA), the way to avoid this is to plan to withhold more money when you start your new job. The absolute safest thing to do would be to list you and your spouse as “married but withholding at the higher single rate” on the first day of your new job with different incomes. With the new tax law coming into effect in 2018, you don’t have to worry about claiming personal exemptions on your W-4 because these were eliminated. Withholding at the higher rate will sting when you get your paycheck but it’s better than having a surprise tax bill, especially if you are new attending.
IRA W-4 Withholding Calculator
The next safest method would be to use the IRS W-4 withholding calculator. You can use this calculator to figure out exactly how much you would owe in taxes and all it requires is a single paystub to do the calculations.
If you have a little more risk tolerance (and have an emergency fund capable of withstanding owing a few thousand dollars at the end of the tax year), you could consider waiting until your January paycheck to increase your withholdings. If you received a refund the year before, this is less risky as you probably have a cushion before you would owe taxes but I would be very cautious with that approach. I hate giving the government an interest-free loan just as much as the next person but do you really want to owe the government thousands of dollars at a single pop just as you are getting on your feet as an attending?
Summary
If you and your spouse have a large difference in income (ours was 430%), then make sure to withhold more money when you start your new job or at least with the new tax year. Hopefully, you can avoid the sting of shelling out so much money to Uncle Sam at tax time.
[Editor's Note: This post illustrates an important principle: The taxes you must pay by tax day, the taxes you must pay and have withheld throughout the year to avoid a tax penalty, and the amount you have withheld are three amounts that theoretically should be similar, but are often dramatically different. Some prefer to be as exact as possible in their estimates, while others prefer to take advantage of the safe harbor rules to in effect, borrow money from Uncle Sam for their own needs. Learn the rules and stay out of the penalty box!]
What do you think? Have you dramatically overwithheld or underwithheld? How did you deal with it? Comment below!
Unless you owed so much that you had to pay penalties, the government made you an interest free loan. Getting a “refund” means you made the government an interest free loan.
Agreed–I’m not sure I understand what the big deal is?
I recently wrote a post on this exact topic. My perspectice is to avoid giving the government an interest free loan that could have been placed towards destroying debt or investing in the market.
I try to use the W4 calculator 2-3 times per year -when I do my quarterly net worth check in – to make sure we are on track to be within $1000 either way on our taxes. Particularly given that the tax laws for 2018 usually result in less taxes for high income earners than what they likely owed in 2017 (not always true).
I think just staying in top of things will typically prevent this problem, but it is definitely an important lesson to learn. No one likes a surprise $8,000 bill!
TPP
My first several years after finishing residency, I worked more and more as an independent contractor in addition to my W2 job. I didn’t make quarterly estimated payments but saved up for tax day from my earnings. I would easily owe over $10,000 but it wasn’t a big deal because I was making a lot of extra money and had it saved. However much I owed at tax day, I would divide up and have additional withholding at my W2 job per paycheck so that way I wouldn’t have to worry about quarterly estimated payments. So evey year the extra withholding kept me in that safe harbor but making even more, I would just save up for the extra tax hit. Never had to worry about penalties. After about 3 years, the income has stopped increasing like it was before, and now I don’t worry about owing at tax day.
I was in private practice and never knew what my income would be by the end of the year. So I took a salary that left a large bonus in December. Then in December I would see what the bonus would be and calculate an estimate of my taxes. Then I could have the balance of my estimated taxes taken out of the bonus. This helped me get very close every year.
Dr. Cory S. Fawcett
Prescription for Financial Success
If you prepare your own taxes, I suggest you take it a step further and use your most recent software edition to estimate your current tax year tax liability. This will work for most tax years, but not 2018, due to the significant tax changes. TurboTax lets you work directly in forms, rather than just the interview, and it allows you to override values, which saves a great deal of effort, e.g., you can override and plug in a single charity estimate in schedule A and avoid the effort to itemize a bunch of donations (I do not recommend working in forms for actual preparation, as the interview approach can help you avoid mistakes). For 2018 estimates you could cap your SALT deductions at $10, 000, eliminate deductions that are restricted, etc. then manually calculate the tax on your taxable income. Alternatively, you could go to TurboTax Taxcaster:
https://turbotax.intuit.com/tax-tools/calculators/taxcaster/
It will give you a 2018 estimate. I find these approaches provide a more accurate picture of my tax liability vs. other methods. Once you become comfortable doing this, you will likely do it a few times a year, as it is useful for what-if analysis, e.g., cap gains impact on an equity sale, ROTH IRA conversions, comparing ROTH 401K vs. conventional 401K contributions, etc.
If you pay for your tax preparation, your preparer should should do the estimating for you.
Thanks for the post. Glad you could cover it. I overpay every year, which irks me existentially, but it is one less hassle in the spring.
When/if interest rates ever get better, it might be a hassle worth doing!
Curious if there was any IRS penalty. If not I wouldn’t consider this a mistake at all on your part. As WCI suggested, staying within the safe harbor — withholding 110 % of prior year’s taxes — may be the easiest option.
I was curious, does anyone know if there is a threshold for how much you owe that you get penalized by the IRS for not having paid it during the course of the year?
For example say you have been withholding money from your W-2 but not your passive income streams which you pay at tax time, what is the amount when the IRS will force you to do estimated quarterly payments for the following year? (and do you get fined for not paying it on the current year?).
The safe harbors that apply to physicians are 110% of previous year’s tax paid (100% if income low enough, probably as residents, or at least 90% of total tax due.
You know this really applies to most folks this year given the tax law changes, not just new jobs folks. Very hard in 18 to do estimated taxes with some of the tax rules not yet fully baked.
In the past, I used TurboTax from my past tax season to estimate my tax burden amount and altered my withholding.
I took quarterly pay stubs from all wages and estimated income and tax withholding by simple multiplication. I entered all information into TurboTax using estimated deductions as well from tithing/charity and property taxes. This gave me a good estimate for my tax well-being because with the use of previous year IRS limits I could assume a small margin of safety and a slightly larger return than calculated.
Of course this year with new Trump tax law I will have to play it safe and keep extra cushion.
When using the IRS calculator, do we include the SS or medicare taxes that are taken out of a W2 paycheck also, or do we only input the FIT withheld so far. I tried it with just the FIT and it showed I will probably owe 10 grand next year, which I wasnt expecting. Looks like I’ll have to adjust our W4s
I had the same issue and question…
I think 2018 is a good year to give the feds an interest free loan by over-withholding. Another poster on this thread described the new tax code as half-baked (agreed). I prefer the certainty of avoiding a tax penalty versus a lost gain in a bubble market.
I kind of feel badly for the employees dealing with this. Those of us who are self-employed know exactly how much to have withheld in order to avoid penalties-110% of what we paid last year. No guess work required. Of course, that may have little to do with the size of the check we write/receive in April.
Why wouldn’t the same be true for employed physicians – withhold 110% of past year’s taxes owed? You’d still be in the same irs safe harbor.
It works, but you’ve got to screw around with a W-4 trying to get there. When you’re doing quarterly estimateds, there’s no W-4 to hassle with. You just multiply your tax bill from last year by 110% and divide by 4 and write the check.
I see. That is fair, it is a lot easier to do the 110% of past year’s tax with estimated taxes than with W-4’s. Thanks so much for sharing your thoughts!
I had a bad experience with state taxes this year because of something I had never paid attention to before because it never made a difference to me. Because of the pending tax law change and the fact that I would probably lose my itemized deductions starting this year, I decided (based on stuff I read on this site) to front-load my charitable contributions for a few years by moving $85K into a donor-advised fund so I could have one big deduction at what would probably (hopefully!) be the highest tax bracket I will be in until the Dems take over and raise rates again. That worked beautifully for federal taxes (the deduction sheltered a large Roth conversion that I did at the same time), but what I didn’t realize was that my state (Michigan) income tax was based on adjusted gross income, not taxable income. That had never really made much of a difference before, but losing the large deduction on my state taxes caused me to be severely underwithheld at the state level and I had to write a large check with a big penalty (mitigated slightly by the fact that these transactions were all done during the last week of the year).
I always owe the government $8,000 in taxes, four times a year. But being an independent contractor there isn’t much I can do about that! The only part of life after kicking the 9 to 5 to the side of the road is taxes. I used to be able to do my own as an employee, but as a self employed guy making a lot less than what I used to no way I can do that by myself any more. Just a cost of being early retired.
I always try to have the largest tax due that avoids a penalty. Whether $8,000 is too large a bill depends on whether there was a penalty. It may have been too little, too much, or just the right amount withheld.
Agreed. Of course, there is also the hassle factor to consider.
Looking for a little help. Switched from W2 employee to K1 partner this year. How much do people typically hold out of their gross paycheck…. 30-40%? And just deposit it into online savings to pay quarterlies?
What was your effective tax rate last year including the payroll taxes your employer paid on your behalf? Hold that much out of your gross paycheck. In my case, it was 32%.