Handling a Loved One's Final Medical Expenses

Taxes and medical bills may be the furthest things from your mind when you lose a loved one. But if you’re the executor (or executrix) of the deceased person’s (decedent’s) estate, you may have to make an important decision about how the final medical bills are handled for tax purposes. By definition, most or all of those final expenses will still be unpaid on the date of death.

Here’s what you need to know.

For income tax purposes, deductions for unreimbursed medical expenses (those not covered by insurance) are normally allowed only in the return for the year in which the expenses are actually paid.

But when a person incurs medical expenses and dies before they are paid, the executor of the decedent’s estate can elect to treat those medical expenses as if they were paid when incurred – as long as the estate pays the expenses within one year after the date of death. In other words, this election allows those expenses to be deducted on the decedent’s final Form 1040, even though they were not paid by the date of death.

Remember that medical expenses can only be deducted to the extent they exceed 7.5% of the adjusted gross income (AGI) reported on the final Form 1040, or 10% of AGI if the dreaded AMT rules apply. The sad truth is, final medical expenses can easily surpass these limitations -- especially when death occurs relatively early in the year, before the deceased loved one has had time to collect much income.

The decedent’s final Form 1040 covers the period from Jan. 1 though through the date of death. The final return is due by the normal deadline, which is April 15, 2010, for a person who dies in 2009 (unless the final return is extended to Oct. 15, 2010).

If the decedent was unmarried, the final Form 1040 includes income collected through the date of death and deductible expenses paid through that date. However, if the executor makes the aforementioned election, a deduction can also be claimed for medical expenses that are paid within a year after death.

When there is a surviving spouse, the final Form 1040 can be a joint return filed by the surviving spouse (as if the decedent was still alive as of the end of the year of death). In this case, the final joint return will include the decedent’s income and deductions from Jan. 1 through the date of death (including unpaid medical expenses for which the election is made) plus the surviving spouse’s income and deductions for the entire year.

The election to deduct unpaid medical expenses on the decedent’s final Form 1040 is made by attaching a statement, in duplicate, to the final return. (If the election is missed, it can be made on an amended final return using Form 1040X.)

To make the election, the executor must waive the right to count those unpaid medical bills as liabilities on the decedent’s federal estate tax return (Form 706). For a wealthy decedent, this waiver could be inadvisable, because unpaid medical bills count as liabilities that reduce the amount of the taxable estate.

So the executor has two options for unpaid final medical expenses:

Option 1: Make the aforementioned election to claim a federal income tax deduction on the final Form 1040.

Option 2: Forgo the election and count the unpaid medical expenses as liabilities on the estate tax return.

Option 2 is worthless when there is no federal estate tax because the value of the decedent’s taxable estate is below the $3.5 million federal estate tax exemption (for those who die in 2009). In this case, the Option 1 election should be made on the final Form 1040 if it would save income tax.

On the other hand, Option 2 is generally the tax-smart choice when the decedent’s taxable estate exceeds the $3.5 million estate tax exemption. Why? Because the federal estate tax rate is 45% while the maximum federal income tax rate is “only” 35%. Also, the full amount of unpaid medical bills can be subtracted on the federal estate tax return without regard to the AGI limitation that applies for income tax purposes.

Be aware that the federal estate tax return (Form 706) is due nine months after the decedent’s date of death (if any return is required). However, the executor can get an automatic six-month extension by filing Form 4768.

If you are the executor, you are now up to speed on the unpaid medical expense issue, but you might still want to consider hiring a pro to prepare the necessary returns.