Despite tax laws that have cut the estate tax bite, survivorship life insurance (SLI) continues as a popular estate planning tool. But it is not the panacea that it was for baby boomers' parents in the late 1980s and 1990s.

Financial advisors consider all estate planning options before using SLI to pay estate taxes. That may be the reason SLI sales have remained flat, according to Howard Drescher, spokesperson for LIMRA International in Windsor, Conn.

"The bloom is off the rose," says Craig Carnack, a Colorado Springs-based CFP licensee. "It is not the solution it once was. It can be part of an overall estate tax plan. It is a method of default if you can't come up with other methods to reduce the estate tax."

SLI can prove a useful way to protect a family's estate that includes hard assets-such as real estate and family businesses that may be difficult to liquidate. Survivorship life insurance, or second-to-die insurance, pays a death benefit when the surviving spouse dies. The policy proceeds are used to pay taxes including estate taxes, gift taxes and generation skipping transfer taxes-or to replace wealth due to transfer of assets.

But the bizarre nature of the sunset provisions governing death taxes make estate planning so vexing some compare it to Russian roulette. This uncertainty is one reason why estate planners are searching for alternatives to SLI policies. Estate tax rates currently range from 45% to 48% of the total current value of all assets above excludable amounts. Under current tax laws, an estate can be transferred to a spouse estate-tax free. Taxes, however, may be due when the second spouse dies.

Apart from this exemption, the first $1.5 million of an estate is not taxed in 2004 and 2005. In 2006, the estate tax exemption rises to $2 million. The exemption increases to $3.5 million in 2009. There is no estate tax in 2010. Unless Congress changes the law, the estate tax exemption becomes $1 million in 2011.

For survivorship life to work, the insurance policy must be placed into an irrevocable life insurance trust, owned by the trust. The beneficiary must be the trust. The trust must be set up at least three years prior to the death of the first spouse, otherwise the insurance proceeds are considered part of the taxable estate. The individual that set up the trust for estate-planning purposes then gifts money into the trust to pay insurance premiums. The person who gifts the money owes gift taxes on amounts over $11,000 per person per year, but gift taxes are not paid until death. There is a lifetime $1.5 million gift tax exclusion in 2004 and 2005. By 2009, the exclusion swells to $3.5 million.

A survivorship policy works this way. Assume that a couple, both 70 years old, will have an estimated estate tax bill of $3 million when the second spouse dies. The annual premium for the policy would be about $32,000 for $3 million worth of coverage. When the surviving spouse dies, the trust uses the policy's proceeds-which aren't part of the taxable estate-to pay the $3 million tax on estate assets outside the trust.

There are pros and cons to purchasing SLI. On the plus side, insurance premiums are 50% less than premiums to insure one person. If the proper financial analysis is conducted, the policy proceeds should cover the estimated estate taxes due. If there is no life insurance coverage, the heirs may be forced to sell assets, such as a family business or other property at below market value because the estate tax bill is due in nine months.

"You have to keep it simple," says James Barry Jr., president of Barry Financial Services in Boca Raton, Fla. "The IRS is challenging exotic trusts and family limited partnerships. But it is easy for clients to understand that the death benefits pay the estate taxes or replace wealth."

Although clients have concerns about paying annual five-figure insurance premiums, Barry says that SLI works well for people with real estate holdings, rollover IRAs and substantial investments in municipal bonds or annuities. IRAs can present a particular problem because they are subject to both estate taxes and federal income taxes. Someone who had to liquidate a $1 million rollover IRA would pay 70 cents on the dollar to the IRS.

Barry often uses immediate annuities as a way to both fund an SLI policy and provide clients with more annual income. Example: A couple, both 70, sell their $2 million investment in tax-free bonds and purchase a joint and survivor immediate annuity.

The net after-tax annual income from the immediate annuity is $122,000, compared with just $45,000 that they had been getting annually from the tax-free bonds they sold. Meanwhile, Barry uses $52,000 of the immediate annuity income to fund a life insurance trust to pay an estimated $2.8 million in estate taxes when the second spouse dies. The remaining $70,000 is annual income to the couple.

Gary Hagar, president of Integrated Wealth Management in Edison, N.J., says he uses SLI with business owners. The life insurance is not subject to creditors' claims. He also uses SLI in deferred compensation plans. The reasons: The mortality and expense charges are low. The policyholder can make tax-free withdrawals for income, which can't be done with an IRA or 401(k) pension plan.

"It (SLI) makes sense as a cash accumulation vehicle," Hagar says. "You can get the greatest possible value at the lowest possible cost."

Despite the advantages, there also are drawbacks. Grant Rawdin, CFP, JD, president of Wescott Financial Advisory Group LLC in Philadelphia, says insurance premiums may be excessive. Someone, for example, with an estate worth $20 million may not want to pay a $500,000 annual premium.

"Survivorship life is often sold to people who don't have liquidity problems and don't need the coverage," he adds. A liquid estate likely could get better returns off investments through different types of trust arrangements, which also can move assets out of the taxable estate," he adds. "But survivorship life insurance does create liquidity. You have leverage if the person predeceases."

Other issues: People with health problems may not be insurable, or they may pay astronomical premiums for coverage. A divorce also could throw an estate plan out of whack. The client may not want to cover a divorced spouse.

"I would use survivorship life in limited circumstances," Carnack says. "You may have a child with special needs. The proceeds would provide wealth replacement to protect the child." Financial professionals report that baby boomers are looking at estate planning at a much earlier age than their parents did. This gives them time to evaluate all client options.

"Today, you must take a comprehensive planning approach to estate planning, rather than just buying a life insurance policy," Carnack says. "In some case it might be better to pay the estate tax bill today, rather than when the value of someone's assets has increased dramatically."

Carnack says he uses trusts as much as possible. The charitably inclined can put assets into a charitable lead trust. There is no gift tax for charitable contributions, and the charity gets income from the trust. When the person dies, the assets go to beneficiaries. Meanwhile, a charitable remainder trust can be used if the surviving spouse wants income from the trust; assets in the trust go to the charity at death.

A business owner with a low cost basis in the company can face a hefty estate tax bill if the business grows, launches a profitable product, goes public or is acquired. Carnack recently had a business owner transfer $1.5 million of his business interest to his children using discounted shares into a family limited partnership. The limited partnership let the business owner maintain control of the company. In the future, the $1.5 million may have grown to as much $10 million dollars. He saved his client millions of dollars in estate and generation-skipping taxes.

Those with highly liquid estates should consider other options to cut the estate tax bill, says Hager of Integrated Wealth Management. Some individuals may be better off making gifts of present interest to their children. Some might set up loan arrangements or use a number of types of irrevocable trusts in addition to charitable trusts. Other types of trusts often used in estate planning include Grantor Retained Income Trusts, which allow an individual to transfer ownership rights to certain assets but retain income or use of the property, and QTIP trusts, which let couples postpone estate taxes until the second spouse dies.

Taxes Imposed On The Transfer Of Assets

Three types of federal taxes are imposed on the assets of the deceased: estate tax, gift tax and generation-skipping transfer tax.

Gift tax is imposed during the lifetime of the giver. Unlimited gifts may be given to a spouse or to charity without tax. And gifts of $11,000 or less per year may be given without taxation. On gifts of more than $11,000, the gift tax rate declines from 48% in 2004 to 45% in 2009. A lifetime gift tax exclusion is satisfied before taxes are paid. In 2004 and 2005 the lifetime exclusion was $1.5 million.

Estate tax is imposed upon death. All assets pass to the surviving spouse free of estate tax. Estate taxes, though, are paid within nine months after the surviving spouse dies. Estate taxes are based upon the total current value of all assets (liquid or not) after all appropriate expenses and appropriate asset transfers. In 2004 and 2005, the estate tax exemption is $1.5 million.

The generation-skipping transfer tax is imposed both at death and during the lifetime of an individual. A decedent (the person transferring assets) has a lifetime excludable gift amount of $1.5 million in 2004 and 2005.

This tax and exclusion is applied to gifts that are for grandchildren, great grandchildren or relatives further down the family tree.

Transferring assets to the skipping generation that are greater than the lifetime exclusion amount also may be subject to an estate tax if the gift is at death. The tax rates in 2004 and 2005 above the exclusion are 48% and 47%, respectively.