As a medical practitioner, it is common to be in the Pay As You Go (PAYG) Instalment system. We break down the basics of this system below to help you understand the impact of PAYG Instalments on your tax affairs.
What are PAYG Instalments?
PAYG Instalments are regular prepayments of your income tax. When entered into the PAYG Instalment system you make regular payments (instalments) of income tax during the year, usually each quarter, with the amount you pay being based on the business and investment income you reported in your most recently lodged tax return.
When you lodge your next tax return, PAYG Instalments are credited against the tax payable on your income. Essentially, the ATO balances the tax you need to pay on your income against the tax you have already paid during the year.
As instalments are based on the income in your last lodged tax return, if your income is higher than the previous year, the PAYG Instalments calculated by the ATO may not be sufficient to cover your tax liability and you will need to pay tax following lodgement of your tax return.
It’s important to note PAYG Instalments are different to PAYG Withholding. With PAYG Withholding, employers pay a set amount of tax to the ATO from the wages and salaries they pay to their employees.
When medicos are earning income under an ABN, there is no tax withheld on this income, therefore, it’s important to regularly save a portion of your income to cover your PAYG Instalments. Most medicos also experience a “tax holiday”, after they start earning private practice income. For example, if they start earning private practice income in July 2022, the tax isn’t payable until lodgement of their 2023 tax return, which could be as late as May 2024. The first PAYG Instalment is usually payable for the June 2024 quarter. Therefore, at the start of your private practice work, you’re often making uneven tax payments long after you earn the income, which is when you need to draw on your tax savings.
When do you enter into the system?
Entering the PAYG Instalment system can either be done automatically by the ATO, when certain criteria are met, or voluntarily. The ATO works out whether you need to pay PAYG Instalments based on information you reported in your tax return. It’s common for medical practitioners in private practice to be entered into the PAYG Instalment system if they are structured as a sole trader or through a trust. The medical practitioner’s spouse may also be entered into the PAYG Instalment system based on distributions from either a service trust, or investment trust.
You will automatically enter the PAYG Instalment system if you meet all of the following criteria:
- Instalment income from your latest tax return is $4,000 or more;
- Tax payable on your latest notice of assessment is $1,000 or more; and
- Estimated (notional) tax is $500 or more.
Instalment income is your gross business and investment income, exclusive of GST. Salaries and wages are excluded from Instalment income, as tax is already withheld on this income. Capital gains are also excluded from Instalment income, as this is generally not recurring income.
Notional tax is the tax payable on your taxable income, adjusted by the GDP uplift rate. We note the ATO has not applied any GDP uplift since the start of the COVID-19 pandemic, and has capped the uplift rate at 2% for the 2023 financial year.
When do PAYG Instalments need to be paid?
Most taxpayers are registered for PAYG Instalments on a quarterly basis. The due date for quarterly PAYG Instalments is generally 28 days after the end of the quarter.
For medicos who are in business, the PAYG Instalment will be included on your quarterly Business Activity Statement (BAS). For taxpayers who are not in business, the ATO will issue an Instalment Activity Statement (IAS) each quarter.
How are PAYG Instalments calculated?
When you prepay your income tax using PAYG Instalments, you may have a choice between either:
- Paying an amount the ATO calculates for you; or
- Calculating your PAYG Instalment yourself using an Instalment rate calculated by the ATO.
You choose your preferred option when you lodge your activity statement and must keep using that option for the rest of the financial year. You can change options on your first activity statement of the new financial year.
Option 1: Instalment amount
Under this option the ATO calculates your PAYG Instalment amount for you based on your most recently lodged income tax return. The amount calculated by the ATO will likely be your most recent tax payable figure divided by how many instalments you pay throughout the year. For example, a medical practitioner with tax payable of $24,000 in their most recent tax return, would pay quarterly instalments of approximately $6,000.
It is important to note that this option can lead to a “Catch-up Payment.” In the scenario that a medical practitioner’s income increases significantly from year to year, such as when they increase the amount of private work they undertake, this can often lead to a large lump sum instalment being due on the June quarterly BAS.
Using the example above, the medical practitioner’s tax payable doubles to $48,000. The taxpayer has currently paid three Instalments of $6,000 for September, December and March. When their income tax return is lodged in May, the taxpayer will be required to meet their new tax payable of $48,000 by making a “Catch-up Payment” with the June 2022 Instalment. In this case, the “Catch-up Payment” is equal to $48,000 less the amount of PAYG that has already been paid ($18,000). As such the medical practitioner will be required to pay a catch-up payment of $30,000.
The ATO will also match the tax payable on the PAYG Instalments with the time elapsed in the financial year, so that by the December quarter, 50% of the estimated tax has been paid, and 75% has been paid on the March quarter. Therefore, if your tax return is lodged in October, your instalment for the December quarter is calculated as your estimated tax multiplied by 50%, less the instalment paid for the September quarter.
Option 2: Instalment Rate
This option is considered to be best if your business or investment income changes a lot, and you want to manage your cashflow. The amounts you pay will go up and down in line with your income. The ATO provides you with an Instalment rate as a percentage, based on the income and expenses in your last lodged tax return. You then calculate the PAYG Instalment by multiplying your Instalment rate by your business and investment income for the period. For example, a medical practitioner with a quarterly business income of $90,000 is given an Instalment rate of 20% by the ATO, therefore their quarterly Instalment would be $18,000.
If your financial situation has changed, your expected tax liability may also change. This means your current PAYG Instalments may add up to more, or less, than your tax at the end of the year. You can vary your instalments so the amount you pay is closer to your expected tax for the year. However, you do not have to vary your PAYG Instalments at all. It will not change how much income tax you pay for the year, just the timing of when you pay tax. In this scenario you can either:
- Pay the PAYG Instalments anyway or;
- Vary your Instalment amount or Instalment rate.
However, it is important to note that if you vary your PAYG Instalments downwards, and it turns out you have a significant tax shortfall at the end of the year (15% or more), the ATO may charge interest and penalties.
If you pay PAYG Instalments using the Instalment amount (Option 1) and your income has increased significantly since your last return was lodged, you may want to vary your instalments upwards in order to avoid a large catch up payment.
If you calculate your PAYG Instalments using the Instalment rate (Option 2) you do not need to vary simply because your income has changed – the payment you calculate will go up and down in line with your income. For this option, taxpayers should only vary their instalments if the taxable proportion of their income has changed – for example, if their income has fallen significantly but deductions for running costs have stayed the same.
You make your variation when you lodge your BAS or IAS. As such, you must lodge on or before the day your PAYG Instalment is due.
The varied amount or rate will apply for the remaining Instalments for the income year, or until you make another variation.