The goal of life insurance in the estate plan depends on many factors specific to the client. However, the goals for life insurance in general can be divided into two categories: life insurance can serve either as an estate enhancement or as an estate liquidity/wealth replacement device. The goals of a specific client for his or her life insurance planning depend on his or her age, family circumstances, and financial status.

A vast majority of individuals have the perception that their accumulated estate will not be as substantial as they would like at the time of their death. In many cases, a decedent�s estate will not be sufficient to provided for the basic needs of his or her heirs. This is particularly true for (1) young clients, (2) clients with family members dependent on their income, and/or (3) clients with small to moderate-sized estates. These clients generally have estate enhancement as the primary goal for their life insurance coverage since they are either too young or have otherwise failed to accumulate sufficient wealth to provide for their heirs. Furthermore, these clients might have their peak earning years in front of them. The basic support needs of their family, such as educational, medical, and retirement savings programs, depend on this income. It is essential for these clients to investigate their life insurance coverage needs and secure sufficient insurance to enhance their estates to a size that is, at the very least, adequate to handle their dependent family members� basic needs. Since their death will cause the loss of income otherwise available to meet those basic needs, life insurance is the perfect estate enhancement device to replace the financial loss created by premature death.

For older clients or clients with large estates, estate liquidity/wealth replacement planning is the primary goal of life insurance coverage. Their children�s support and educational expense needs are usually a thing of the past. In addition, these older clients are nearing the end of their income-producing years and should, presumably, have less income to replace. If they have accumulated enough wealth or have an adequate retirement plan, their needs for estate enhancement from life insurance should have diminished in importance relative to their estate liquidity/wealth replacement needs.

A prospective insured may need coverage for estate liquidity/wealth replacement for the following purposes:

The problems faced by wealthy individuals� estates and heirs can often be mitigated by life insurance. For these individuals, the goal of life insurance is estate liquidity or wealth replacement. The wealthy client can purchase life insurance to provide death proceeds equal to the size of the anticipated shrinkage of the estate for death taxes and other settlement costs. In addition, because the life insurance benefits are paid in cash, the estate can be settled immediately. Thus, the nonliquid assets can either be retained by the estate to distribute to family heirs or sold later when an appropriate buyer can be found.

Much of the discussion that follows concerns the appropriate design of life insurance for estate liquidity purposes. It is important to arrange life insurance coverage appropriately to solve individuals� estate liquidity problems. An inappropriate life insurance plan can lead to the inefficient use of life insurance as an asset in the estate plan. Improperly designed, life insurance will add to the estate�s settlement costs.

There are many practical uses for life insurance in the estate planning context. We will now discuss the following:

Although the 3-year rule causes estate tax inclusion if the insured transfers incidents of ownership within 3 years of his or her death, transferring or assigning the policy to family members might still be an appropriate planning step. The insured simply has to live more than 3 years following the transfer to avoid inclusion of the proceeds in his or her gross estate. And even if the insured dies within 3 years, he or she will be no worse off from an estate tax standpoint since the policy would have been included in any event had the transfer or assignment not occurred.

There are many reasons why estate planners recommend a life insurance policy gifting program. Some of the reasons include the following:

One useful estate planning device involves gifting a life insurance policy to a revocable trust. Although there are no tax benefits in using the revocable trust approach, the trust is advantageous because it provides asset management and dispositive flexibility. It should be noted, however, that revocable life insurance trusts do not offer protection from estate taxes, do not shift the burden of income taxes, and generally do not affect state death taxes.

The revocable trust works extremely well in cases where estate tax planning is not the life insurance plan�s primary concern. For example, a young couple with minor children might find a revocable trust to be helpful in their plan. If the total family wealth (including policy death benefits) is less than the unified credit equivalent ($600,000), federal estate tax will be avoided, regardless of the life insurance plan design. Even if the couple�s wealth exceeds $600,000, the unlimited marital deduction could shield the deceased spouse�s estate from immediate taxes. Estate taxes will probably be deferred for many years unless both spouses die prematurely, an unlikely event. Under these circumstances, because the primary need for life insurance is estate enhancement, a revocable trust could be created to receive policy proceeds. At the death of the grantor-insured, the trust would become irrevocable. The trustee would then manage the proceeds for the surviving spouse, if necessary, and the minor children.

If the insured is older and wealthier, and if larger policies are involved, setting up an irrevocable trust to serve as the owner and beneficiary of a life insurance policy is often recommended. Irrevocable life insurance trusts holding policies on the life of the grantor or his or her spouse offer attractive estate-tax-saving opportunities (even though trust income used to pay policy premiums may be taxed to the grantor for income tax purposes).

An irrevocable life insurance trust is often the best solution to an estate owner�s liquidity problems.

Unless the executor of an estate wishes to go through a series of complex and burdensome requests for an extension, the tax due by an estate must be paid within 9 months of the date of death. If the gross estate is composed of liquid assets, the executor or administrator faces no problem in meeting the 9-month deadline successfully. For example, if the estate is composed of sufficient cash, marketable securities, or life insurance proceeds, there will be ample liquidity to ensure that the tax can be paid within the required time. Conversely, if the federal estate tax liability exceeds the amount of liquid assets available, there will be an estate liquidity deficit. To meet the 9-month deadline, a forced liquidation of assets�possibly at a loss�will be necessary.

Estate liquidity deficits frequently occur when a decedent owns a closely held business interest at the time of death. The fair market value of this asset must be included as part of the decedent�s gross estate, which results in a higher federal estate tax liability.

Life insurance is the most effective way to supply needed dollars to meet federal estate tax obligations. First, the dollars, in the form of death proceeds, are free of federal income taxation. Second, if the life insurance is owned by someone (or some entity) other than the insured, the policy�s face amount will not be included as part of the decedent�s gross estate. Finally, the sizable death benefit may be purchased for pennies on the dollar in the form of premium payments.

Few situations are more tragic than a forced liquidation of a family business and other personal assets to pay federal estate taxes when the surviving family members depend on the income that is derived from the business. Life insurance is a viable way to assure a family that a forced liquidation for this purpose will never be necessary.

There are many estate planning situations in which it is the estate owner�s wish to equalize inheritances among children.

A prime example is when an estate owner has brought some of his or her children into a family business and intends to provide these children with an ownership interest in the enterprise. The plan may be to pass the interest to these children either during the estate owner�s lifetime or after his or her death. However, if there are other children in the family who have no contact with the business, the estate owner may wish to provide other assets for those children so that there is equality among all of his or her children. Life insurance in this context is appropriate.

The use of a survivorship (second-to-die) policy should be considered in estate planning for a married couple. The federal estate tax marital deduction is now unlimited in nature and scope. With the advent of the unlimited federal estate tax marital deduction, however, came an increased potential for overqualification for the marital deduction. There is a greater propensity by estate owners to leave their entire estates to their surviving spouses, which assures no estate tax liability at the first death.

There is, unfortunately, a serious flaw in this approach. The concept of the federal estate tax marital deduction is based on a deferral of estate tax liability�it is never to be thought of as a complete avoidance of the estate tax. Although the deduction is unlimited, to use the deduction to its fullest extent creates a stacking of estate taxes at the second death. The estate tax liability from the estate of the first to die is added to the estate of the second to die. The result is a higher estate tax liability overall.

The unlimited marital deduction has created a need for greater planning for the death of the second spouse. That is why the second-to-die policy was instituted. Many life insurers offer a second-to-die policy that jointly insures a husband and wife. At the death of the first spouse, no death benefit is paid; at the death of the second spouse, the policy proceeds are paid to the named beneficiary. (The second-to-die product is discussed fully in chapter 4.)

Second-to-die coverage is often a perfect fit in a married couple�s estate plan. The most common use of second-to-die coverage is in an estate plan in which taking the unlimited marital deduction after the death of the first spouse will result in more substantial death taxes at the death of the second spouse. With second-to-die coverage, policy benefits will be paid when the insured married unit incurs these more substantial taxes�at the second death of the two spouses.

Second-to-die life insurance works particularly well with the current estate tax system. However, the financial services professional should never ignore the first death coverage needs when assisting in the estate planning process.