Changes in tax laws can catch successful people off guard. With most physicians so busy worrying about potential reimbursement reductions, they don’t have the time to address the important challenge of establishing a tax-wise estate plan for their families. In our experience, fewer than 5% of doctors have an adequate estate plan in place when we meet. This upcoming tax law change will create even more shortfalls in most doctor families’ planning.

We see that physicians typically make one or more of these three common mistakes:

Unnecessarily losing up to 50% of life insurance proceeds to taxes;

Leaving too much value in the taxable estate; or

Losing up to 70% of the value in a qualified retirement plan or IRA.

Fortunately, there are a few simple tools doctors can use to help circumvent such mistakes and allow their families to avoid the unnecessary costs that come with poor estate planning.

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

Financial consultants highly recommend using life insurance as a tool to pay the estate taxes that may be due when a physician dies. The funds are available immediately to surviving family members, without the delays or expenses involved in liquidating tangible assets. Nonetheless, many physicians fail to establish a simple trust that, if established properly, enables all of the proceeds from a life insurance policy to be estate tax-exempt and available to a surviving spouse at the same time.

One common misconception most physicians have about life insurance is that all insurance proceeds are exempt from estate taxes. This idea is not true. Life insurance proceeds are exempt from income tax, but they are subject to both federal and state estate taxes. Federal estate tax rates, are now at 35% temporarily and are scheduled to increase within 2 years. Physicians’ family members should not lose a large percentage of the life insurance policy proceeds when a simple legal tool can solve this problem and provide better lawsuit protection for insurance beneficiaries.

A good way to avoid losing a significant portion of life insurance proceeds—or possibly any proceeds at all—is to establish an irrevocable life insurance trust (ILIT). As the name implies, an ILIT is a trust that owns a life insurance policy. The ILIT can save a physician estate taxes because it, rather than the physician personally, owns the life insurance policy. Since the policy is not held in the doctor’s name, the policy proceeds will not be part of his or her net estate at the time of death, as long as the physician survives three years from the time of the transfer to the trust. The proceeds therefore are not subject to estate taxes. Such a trust can save a physician’s family a great deal of money. An ILIT is indispensable for life insurance policies owned for estate planning purposes. This type of ownership is ideal for estate planning but not for those tax-savvy investors who are using life insurance to generate tax-efficient retirement wealth.

The ILIT gives the insured much more control over what happens to the policy proceeds than he or she would get from a beneficiary designation of an insurance policy. With an insurance policy alone, the only decisions the insured can make is to whom to leave the proceeds and whether to pay all the money out in a lump sum or over a specific period of time (with an annuity payout option).

With an ILIT, however, the insured can control not only who receives the proceeds but also exactly what happens to the funds when he or she dies. The ILIT can require the trustees to pay the beneficiaries immediately in a lump sum or pay them over months or years – with more creativity than a beneficiary designation offers. The insured can also incorporate spendthrift provisions and anti-alienation provisions to protect the surviving family members against their own financial problems or their spouse’s financial woes. The ILIT offers tax reduction, asset protection, and planning creativity that cannot be achieved with a simple beneficiary designation.

For these reasons, every physician should consider an ILIT when purchasing a life insurance policy that is to be used as part of a well-crafted estate plan.

For physicians who have already purchased a life insurance policy or who are currently making payments on an existing policy, it is not too late to establish an ILIT. A policy can be transferred to an ILIT at any time. There may be some gift-tax issues associated with such a transfer, but these issues are likely to be minor compared with the potential tax savings a physician’s family could enjoy.


Mistake #2: Leaving Property to the IRS

We do not know of any physicians who have left property to the IRS intentionally. If the physician or his estate has not implemented a gifting program in the doctor’s lifetime, the end result is often the same. After a certain exemption amount (which is set to return to $1,000,000 in the upcoming years), any property not given away during a physician’s lifetime will likely be taken in part by the IRS. To prevent having to make this payment, physicians can gift property to family members.

Most physicians initially hesitate to begin a gifting program, believing that they will have to give up control of the underlying assets. But control of the assets is not necessarily given up in such programs. Instead, a physician can use legal entities to remove asset values from his or her estate, and still maintain complete control of the assets while still alive.

Through such entities as family limited partnerships (FLPs) and family limited liability companies (FLLCs), physicians can share ownership of their property with family members and maintain control of the property at the same time. Using this strategy, the physician and his or her spouse can give as gifts ownership interests to their children over time, using their combined annual gift-tax exclusions. Doing so removes those interests from their estates for tax purposes. But as long as the physician and the spouse are the general partners in the FLP or the managers of the FLLC, they will maintain control of the underlying assets.

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

The vast majority of the assets in pensions, 401(k)s, and IRAs could end up being owed to state and federal tax agencies when a physician dies. It is an unpleasant truth that after paying taxes for a lifetime of work a physician’s tax qualified plans could be taxed at rates above 70 percent. When hearing these facts, most physicians are shocked and want to learn how to do something about it. The good news is that there are techniques that can be incorporated to avoid this loss of wealth. While such techniques are too involved to be described in a short article, with advanced planning the threat of taxes decimating a qualified plan can be eliminated. A professional financial consultant can examine qualified plans and advise clients on which strategies will save them the greatest amount of their wealth.

Conclusion

Many otherwise sophisticated clients put their families in an estate planning mess because of three common mistakes: losing life insurance proceeds to taxes, leaving property to the IRS, and losing large percentages of the value of qualified retirement plans. Clients with larger estates have even more potential pitfalls to avoid in their planning. While educating oneself regarding the potential errors in the estate planning arena is important, as in the practice of medicine, there is no substitute for a consultation with an experienced, licensed professional. An estate planning physical with a financial planner is the real first step in any worthwhile estate plan.

COMMON MISTAKES & TOOLS TO HELP AVOID THEM

Mistakes	Desired Benefit	Tool	Cost
Losing 50% of Life Insurance to Taxes	Proceeds Estate-Tax Exempt	ILIT	$2,000-$4,000
Leaving Toom Much Value In Taxable Estate	Remove Value From Estate While Keeping Control	FLP, FLLC	$5,000 and Up
Leaving Too Much Value In Qualified Plan	Eliminate 80+% Tax Bite on Such Plans	Advanced Planning; Call for Details	Varies

The authors welcome your questions. You can contact them at (877) 656-4362 or through their website http://www.ojmgroup.com

SPECIAL OFFER: For a free (plus $5 S&H) copy of For Doctors Only: A Guide to Working Less and Building More, please call (877) 656-4362.

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 (http://www.guardpub.com) who offer CME seminars and other programs for groups, hospitals and societies.