ESTATE PLANNING

5 Estate Planning Mistakes Every Planner Should Avoid

By Bob Morrison

Neglecting a client’s estate plan can have a huge impact on a surviving spouse or their heirs.

In terms of its impact on beneficiaries, estate-related income tax planning is far more impactful than traditional estate planning for most clients today, due to the increase in the estate tax exemption from $5,450,000 per person in 2017 to $12,920,000 for 2023. Only 2,000 to 3,000 decedents who died in 2019 were subject to estate taxes, according to the Heckerling Institute on Estate Planning. Income tax planning and basis management as they relate to clients’ estates will have a much larger impact than traditional estate planning on the vast majority of our clients’ heirs—at least at the federal level.

It’s also important for us to review our clients’ estate planning documents. Assets may be inherited by parties that the deceased party never intended, if we don’t focus on this important area and review wills, trusts, and beneficiary forms, including payable on death beneficiary forms.

I presented “25 estate planning mistakes to avoid” at the NAPFA Fall Conference last year. Here are five of them.

1. Leaving the Wrong Assets to Charity at a Client’s Death

When reviewing a client’s will or beneficiary documents, pay close attention to which assets are left to charity. Because taxes are incurred by individuals but not charities, leaving charities the right assets can maximize the benefits that individuals receive while achieving the donor’s intentions and not reducing the amount that the charities receive.

When I’ve seen clients consider giving substantial assets to a charity in a will, I speak to them about the tax impact of giving an IRA to an individual versus giving it to charity. Individuals will have to pay taxes on the IRA while a charity will pay no tax regardless of the asset received. Giving charities the IRAs eliminates the tax that would be due if those same funds went to heirs. This strategy leaves more after-tax dollars from other sources to individual heirs, which are much more valuable to them from a tax perspective. IRAs cannot be bequeathed via a will; they must be left via beneficiary documents from the IRA’s custodian.

Most heirs today who are not spouses are non-eligible designated beneficiaries (NEDBs), according to the SECURE Act. These NEDBs must pull out all the funds in 10 years, making pretax IRAs that much more unappealing from an income tax perspective, compared to after-tax assets or Roth IRAs. In contrast, after-tax assets inherited by individuals receive a potentially valuable step-up in basis, and individuals pay no tax on inherited bank accounts, real estate, or brokerage accounts. Giving Roth IRAs to a charity is a cardinal sin in terms of taxes if there are other assets to give because the charity doesn’t benefit from the tax break, and this move may increase the taxes payable by individual heirs.

2. Paying PR Versus Giving Assets via Inheritance to PR

Doing the work as a personal representative (PR) can be extraordinarily time-consuming. PRs also have a fiduciary responsibility and legal liability. I believe all PRs should be paid for these two reasons. PRs can take a fee out of the estate for their services, but this is taxed as ordinary income. I believe an amount should be set aside for the PR to inherit instead of paid out of the estate. Create a small bank account or designate a small portion of a brokerage account to pay the PR to avoid the tax bill. You can set up either of these as payable on death.

3. Splitting Assets Evenly Between All Heirs Without Considering the Tax Impact on Each Person

Most clients want to split their assets based on gross amounts without considering the tax impact on each recipient heir. I talk to clients about the after-tax consequences of their actions. I ask them if they want more money to go to their heirs or to the IRS and state departments of revenue. Thinking of the after-tax dollars to be received by an heir has become more important since the SECURE Act passed in 2019 because now most non-spouse beneficiaries must pull all money out of the IRA in 10 years.

The downside of an even split and an example of how to remedy it are in the case study at the end of this article.

4. Surviving Spouse Not Filing the Form 706 Estate Tax Return

There are two reasons why an IRS Form 706 needs to be filed. The first is to pay estate tax, though only 2,000 to 3,000 decedents each year owe estate taxes, thanks to the high federal minimum of over $12.9 million for 2023. The main reason to file Form 706 is to get portability for a surviving spouse on the deceased spouse’s unused exemption. If the spouse doesn’t file Form 706, then the surviving spouse is leaving the deceased spouse’s unused exemption on the table. This is a big risk with the exemption set to be cut by 58% to $5.4 million on Jan. 1, 2026, when the current exemption level, created by the Tax Cuts and Jobs Act, sunsets if Congress does nothing.

5. Not Considering Direct Payment of Education and Medical Expenses for Family or Friends

Direct payments for educational and medical expenses for family or friends receive unlimited exemptions if paid directly to the educational institution or directly to the medical provider. These gifts do not reduce the gift or estate tax exemption. They are always tax-free—even if the exemption is used up.

Give Estate Planning the Attention It Deserves!

As these examples show, estate planning deserves attention equal to all the other financial planning areas, even if your clients don’t have assets anywhere near the upper limit of the federal exemption. Your clients have worked hard to accumulate their assets during their life. They need you to make sure things happen according to their wishes at their death.

Case Study of How an Even Split Can Yield Uneven Results and Higher Overall Taxes

The client in this example has $2 million in IRAs and $2 million in brokerage accounts. The client has a son and a daughter when she passes away. The son is married, and his spouse does not work and stays home with the kids. The son makes $70,000 and is in the 12% married bracket. The daughter is a single, high-earning executive who makes $215,000 and is in the 35% single bracket. Let’s also assume that the son lives in Texas with no income tax, and the daughter lives in California and pays 10% state income tax at her income level.

If the assets are split evenly between the heirs, each child will receive $1 million in an IRA and $1 million in a brokerage account. Let’s assume that each child takes an even amount over 10 years and, to simplify the example, there is no growth in the account. With each annual $100,000 withdrawal, the son will owe federal income tax of $18,705 and no state income tax because he lives in Texas. In contrast, the daughter will owe more than twice as much each year: $35K in federal taxes and $10,000 in state taxes. Over the 10 years, the son will pay $187,048 for his inheritance. The daughter will pay $450,000 in federal and state income taxes over this period for her inheritance. This means the daughter will receive $550,000 from the $1 million IRA. The son will receive $812,952 from his IRA. If the assets are split evenly without considering taxes, the heirs pay $637,048 in taxes on the IRA distributions.

If we were to look at this in the most tax-efficient manner possible, we should give all of the IRA to the son because he will be in the lowest tax bracket—even with the $100,000 distributions for 10 years. If we do this, the son will owe $42,022 per year for a total of $420,220 paid over the 10-year period. The son would net $1,579,780 on the $2 million in IRAs. The daughter would then receive $1,579,780 from the brokerage account, and this would leave $420,220 from the brokerage account that would be split evenly between the two children for a total of $1,789,890 after taxes for each of them. The taxes paid to the IRS in total between the two heirs is reduced from $637,048 to $420,022 under this scenario.

Bob Morrison CPA/PFS, CFP^®, is president of Downing Street Wealth Management LLC in Denver. Bob is a Fee-Only planner specializing in estate and tax planning for pre-retirees and retirees.

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