Improper planning can result in needlessly paying death taxes. The top federal death tax bracket is 48%, and some retirement plans can be taxed at a cumulative rate of 80% to 90%. Tax laws are in a constant state of flux, and physicians need to consult periodically with qualified tax and legal advisers to avoid excess tax liability upon death.
Mistake 1 Failing to Plan
By far the biggest and most widespread mistake physicians make is simply failing to plan their estates properly. Some may not be aware of the existence or the magnitude of death taxes. Others may assume that their estates are not large enough to be taxed or that the taxes won’t exist when they die. Others are too busy to focus on the process and get it done. As the saying goes: “You can be certain of only two things: death and taxes.” Failing to plan properly for the occurrence of the two can be financially catastrophic for a physician’s family. Under the current tax law, the federal estate tax kicks in for estates of more than $1.5 million at a 45% bracket and reach a top tax bracket of 48%. The total of $1.5 million may seem like a lot of money, but many people are surprised at how quickly their estates reach this level when they start totaling all their assets and life insurance.
Action Step Physicians should consult an attorney experienced in estate planning and start looking into the available planning opportunities. The earlier they start planning, the better off they will be.
Mistake 2 Not Taking Advantage of State Death Tax Opportunities
So much attention is focused on planning for the federal estate tax that it is possible to overlook opportunities at the state level. In addition to the federal estate tax, many states impose their own form of death tax. Fortunately, the state rates usually pale in comparison to those of the federal estate tax, but they are still worth addressing, especially when moving from one state to another. For example, a physician who had some planning done while in residency in one state but then took a position with a hospital in another state may mistakenly assume that the current estate planning documents are adequate.
Action Step Physicians should talk with their estate planning professionals to ensure that they are taking advantage of all state death tax savings opportunities. When physicians relocate to another state, they should have a local attorney review their existing documents to ensure that they pick up any savings under the new state’s laws.
Mistake 3 Failing to Coordinate Assets With the Estate Plan
The most comprehensive set of wills and trusts can be rendered useless from a tax planning perspective if the assets are not properly coordinated with the estate plan. To understand why, it helps to have an idea of how property passes at death. A will generally controls only those assets that are owned in an individual’s name with no beneficiary designation. If most of the physician’s assets are titled jointly with someone else (such as a spouse) so that they pass outside of the will, or if everything is subject to a beneficiary or “transfer on death” designation so that they also bypass the will, there may be few if any assets passing through the will to take advantage of the tax planning strategies it provides. In general, it is important that both spouses have assets in their individual names, which is not often the case when the working physician spouse accumulates all of the retirement plans and is the insured under all of the life insurance.
Action Step Physicians should make certain that their adviser works with them on the coordination of their assets when their estate plan is done, and they should initiate an annual review of that plan. Proper implementation of the plan is critical.
Mistake 4 Not Taking Advantage of Lifetime Gifting Strategies
The federal estate and gift taxes are a combined system of taxation. Under the current law, everyone is allowed to gift as much as $11,000 annually per person free of the federal gift tax. The flip side of that is that any dollar gifted in excess of the $11,000 annual gift tax exclusion starts to “use up” the $1.5 million that can be left free of the federal estate tax at death. While this strategy may not be for everyone, it sometimes makes sense to make gifts of as much as $11,000 per year to individuals in younger generations. Not only does this strategy remove the gifted asset from taxation in the estate, it also removes all future appreciation of the asset starting from the date of the gift.
Action Step Physicians should consult their adviser and consider whether it makes sense to start gifting to younger generations now, especially since Uncle Sam may end up with 48 cents of every dollar that they fail to gift, thanks to the federal estate tax. There are a variety of sophisticated gift-giving options that may have drastic effects on the physician’s tax planning and asset-protection strategies.
Mistake 5 Failing to Update Beneficiary Designations on Life Insurance
Although this mistake is related to Mistake 3, it is worthy of its own mention given how often problems occur in this area. Life insurance comprises a substantial portion of the estates of many physicians and is purchased for a variety of intended uses. All too often, though, the ownership and the beneficiaries of the policies are not what they should be, either because of new circumstances involving the insured’s family, business, or previous estate planning, or as a result of tax law changes. The potential inconsistencies are too numerous to list.
Action Step Physicians should make certain that their advisers are aware of all insurance coverage in place, even a group policy that they took out years ago during residency and which may still list their parents as beneficiaries. They should also make sure that the primary and contingent beneficiaries are named as they should be on each policy. Additionally, it is critical to determine the correct ownership of these policies, since one should never assume that the insured should always be the owner.
Mistake 6 Having Incorrect or No Beneficiary Designations on Retirement Plans
Also related to Mistake 3, this mistake merits its own mention. A few years ago, in a stroke of uncharacteristic compassion toward taxpayers, the Internal Revenue Service simplified the rules regarding minimum required distributions from retirement funds and actually made it easier to plan with them. That is the good news. The bad news is that retirement plans can be subject to a multitude of taxes, including income tax, state death tax, and federal estate tax. If not properly planned for, the cumulative tax rate can reach 80% to 90%. Retirement funds are another asset that often comprises a large portion of physicians’ estates.
Despite the simplification of the tax laws, there are still no easy answers. Physicians need to consult an adviser who knows the rules and can work through the possibilities in light of what the physicians are trying to accomplish from both a retirement and an estate-planning perspective. Potentially, the worst-case scenario for tax purposes is to have named no one as a beneficiary on the retirement plans. So, if physicians do nothing else, they should make sure that they have both a primary and a contingent beneficiary named, as well as make certain that those beneficiaries are actually the persons whom the physicians want to receive the retirement funds upon their death. Remember that a beneficiary designation trumps the provisions of the will.
Mistake 7 Failing to Address Business Succession Planning Issues
Many physicians have an ownership interest in their practice, whether it is through a corporation, a limited liability company, or some other entity. Potentially, a properly drafted buy-sell agreement can save an estate thousands of dollars in taxes by valuing the business assets appropriately. Having such an agreement is also critical in order to handle issues smoothly that otherwise would be disruptive to many businesses.
Action Step Physicians should consult with their adviser to document and implement an appropriate buy-sell agreement among themselves and their partners.
Mistake 8 Failing to Coordinate Professionals
Most physicians have numerous professionals with whom they work, such as a stockbroker, an accountant, and an attorney. Too often, these professionals never talk to each other to coordinate what they are individually doing for their physician client. The stockbroker should have an understanding of what the physician has structured from an estate planning point of view, so that as questions arise regarding the titling of account, for example, the stockbroker can properly inform the physician. Likewise, the accountant should be aware of any potential transactions that might affect the physician’s income tax liability for the year.
Action Step Physicians should make sure that each of their professional advisers knows of all their other professional advisers. Physicians should ask that they consult each other (which might require making telephone calls or provide them with some form of written consent to do so) prior to making decisions that could affect the work that the others are doing on the physicians’ behalf. For example, a physician’s estate planning attorney and accountant may have agreed on a specific way for the physician’s assets to be titled for purposes of the estate plan. That plan could be completely undone by the physician’s stockbroker if he or she is not aware of the details of the plan and automatically titles a new account or purchases a new holding differently.
Mistake 9 Failing to Update
Unfortunately, life and tax laws are not static, which is very much the case with the federal estate tax. As mentioned earlier, the current exemption from the tax is $1.5 million. The exemption amount will continue to increase as shown in the following table:
For estates of decedents dying during
The applicable exclusion amount is
2004 and 2005
2006, 2007, and 2008
Beginning in 2010, the federal estate tax will be eliminated, but a substantial alteration of the rules regarding the “step-up” in basis that is generally granted to inherited assets (for income and capital gains tax purposes) will be added in. In 2011, however, the estate tax comes back into effect and the excludable amount will drop once again to $1 million. Although this change is confusing, it is crucial that physicians keep informed of these changes, especially if their total estate (including life insurance) exceeds the exclusion amount. Documents may need to be revised and assets may once again need to be retitled, all in order to make certain that the physician’s estate can take advantage of changing tax laws.
Action Step Physicians should consult with their advisers and ask that their estate plan be reviewed annually if necessary in light of the tax law changes and changes to their family and financial situations. Creating flexibility in the plan documents is also important.
Mistake 10 Failing to Carry Proper Levels of Life Insurance
Despite the increasing exemption amounts, many physicians still find themselves with a taxable estate as value builds in retirement plans and practices. Sometimes the issue is not so much how to avoid taxes, but how to pay the taxes that might be due upon death. For example, despite the illiquidity of the assets in an estate with a highly valued practice, large retirement fund, or piece of real estate, the taxes are still due on the value of those assets nine months from the date of death. Rather than being forced to sell assets at a fire sale to raise cash, it may make sense to purchase properly structured life insurance (in terms of amount, ownership, etc.) to provide liquidity to cover the tax liability.
Action Step Physicians should consult their estate planning attorney to prepare a liquidity analysis of their estate given their assets and potential tax liability. If necessary, they should then work with an insurance agent who can assist them with purchasing and properly structuring life insurance coverage.
All physicians, regardless of whether they have already done some estate planning, should be cognizant of these mistakes and take steps to protect their estates from the payment of unnecessary death taxes. Consultation with counsel at an early stage is critical.
Philip A. Goldblum, Esq., and Theresa A. Malmstrom, Esq.