Three of the Greatest Physician Estate Planning Mistakes

October 14, 2009
Christopher R. Jarvis, MBA

In addition to identifying the Three Big Mistakes, the authors discuss simple tools that doctors can use to avoid unnecessary costs which come with poor planning.

Like many successful people, physicians are often so busy dealing with their practices and personal lives that they never take the time to deal with the important challenge of creating a tax-wise estate plan for their families. In fact, in our practices, we have found that fewer than 5% of doctors had a proper estate plan in place when we met.

In this article, we will examine three of the most significant mistakes physicians make when creating (or ignoring) their family’s estate plan. We’ll also cover simple tools that the doctor can use to help avoid such mistakes and allow one’s family to elude the unnecessary costs which come with poor planning.

Mistake #1: Losing Half of Life Insurance Proceeds to Taxes

Life insurance is highly recommended as a tool to pay the estate taxes due when you die — because the funds will be available immediately to your survivors, without any delays or expenses involved with liquidating tangible assets. Further, clients who set up policies in advance of their retirement years enjoy powerful leveraging of today’s dollars. Nonetheless, many fail to utilize a simple trust that, if set up correctly, enables all of the insurance proceeds to be estate tax-exempt.

Why the IRS May Get Half of Your Policy

The greatest misconception most clients have when it comes to life insurance is that the proceeds are estate tax exempt. This is absolutely wrong! The proceeds are income tax exempt, but are subject to both federal and state estate taxes. Federal estate tax rates, now and under current proposals, will likely be in the 45% range — plus state estate and inheritance taxes as well. Why lose a possible fortune of your policy proceeds after you paid those premiums so diligently … especially when a well-structured trust can take the IRS out of the picture and provide better protection for your beneficiaries?

Preventative Medicine: Using Irrevocable Life Insurance Trusts (ILITs)

An irrevocable life insurance trust (ILIT) is simply an irrevocable trust that owns a life insurance policy. The ILIT can save you estate taxes because it, rather than you personally, owns the life insurance policy. Because the policy is not owned in your name, the policy proceeds will not be part of your net estate when you die (as long as you survive 3 years from the transfer to the trust). Thus, the proceeds will not be subject to the estate tax. This can save your family a great deal of money — and is a must for policies owned for estate planning purposes – as opposed to those designed to generate retirement wealth.

ILITs Give You Control

The ILIT gives you much more control over what happens to the policy proceeds than you would get from a bare insurance policy. With an insurance policy alone, your only decision is to whom you will leave the proceeds (the beneficiaries) — the insurance company will simply pay these people when you die.

With an ILIT, on the other hand, you can control not only who gets the proceeds and exactly what happens to the funds when you die. You can have the trustee pay the beneficiaries directly or pay them over a period of months or years. You can incorporate spendthrift provisions and anti-alienation provisions to protect against your beneficiary’s (children’s) financial problems or their spouse’s financial woes. In fact, an ILIT gives you all of the benefits of a trust arrangement — while allowing you to provide for your family just as you would with a bare insurance policy.

For these reasons, an ILIT should be considered when owning a life insurance policy in a physician’s estate plan. Of course, there is a significant drawback to ILITs, especially for policies with cash value — once the policy is transferred to the trust, you will no longer have access to the cash value.

Note: If you have already purchased a life insurance policy or are presently making payments on an existing policy, it is not too late. You can always transfer a policy to an ILIT. There may be some gift-tax issues associated with this maneuver, but they are likely to be minor compared to the potential tax savings your family could ultimately enjoy.

Mistake #2: Leaving Property to the IRS

While no physician leaves property to the IRS intentionally, quite often this is the effect of a physician’s estate if he/she has not implemented a gifting program during his or her lifetime. Simply put, after the exemption amount, any property not given away “in title” during your lifetime will likely be taken in part by Uncle Sam. To prevent this — along with the strategies explained above – clients can gift property to family members.

Most clients initially hesitate to begin a gifting program, as they think they will have to give up control of the underlying assets. As you’ll see below, this is not necessarily true. Instead, one can use legal entities to remove asset values from one’s estate, while maintaining 100% control of the assets while one is alive. •

Preventative Medicine: Gifting Using FLPs and FLLCs

Through entities like family limited partnerships (FLPs) and family limited liability companies (FLLCs), you can share ownership with family members … yet maintain control. In this strategy, you and your spouse gift ownership interests to children over time (using your combined annual gift tax exclusions), removing those interests from your estates for tax purposes. Still, as long as you and your spouse are the FLP general partners or LLC managers, you will maintain control of the underlying assets.

Mistake #3: Losing 70%+ of Pensions, 401(k)s, and IRAs to Taxes Unnecessarily

Would you be surprised to know that the vast majority of the assets in pensions, 401(k)s, and IRAs could end up with state and federal tax agencies? Did you think that — after paying taxes for a lifetime of work – your “tax qualified” plans could be taxed at rates above 70%? Most physicians – when hearing these facts – are shocked, appalled, and want to learn how to do something about it. While the details of such techniques are beyond the scope of this article, suffice it to so say here that – with advanced planning – the threat of taxes decimating a qualified plan can be eliminated.

Conclusion

Many otherwise-sophisticated clients put their families in an estate planning mess because of the mistakes covered above. Clients with larger estates have even more potential pitfalls to avoid in their planning. Thus, this article’s true purpose is to serve as an “eye opener.” While educating oneself as to the potential errors in the estate planning arena is important — as in medicine – there is no substitute for consults with a licensed professional experienced in these matters. In this way, an estate planning “physical” is the real first step in any worthwhile estate plan.

Mistakes

Desired Benefit

Tools

Cost

Allowing Life Insurance to be Estate Taxed

Proceeds Estate-Tax Exempt

ILIT

$2000-$4000

Leaving Too Much Value in Taxable Estate

Remove Value From Taxable Estate While Keeping Control

FLP, FLLC

$5000 and up

Leaving Too Much Value in Qualified Plan

Eliminate 80+% Tax Bite on Such Plans

Advanced Planning Call for Details

Varies

Christopher Jarvis and Jason O’Dell are principals of the financial consulting firm O’Dell Jarvis Mandell LLC. Jarvis and Mandell have co-authored seven books for doctors. They are speakers for Guardian Publishing who offer CME seminars and other programs for groups, hospitals and societies.