I received this question from S.L., of Brooklyn, N.Y., who wrote:

I'm concerned about paying the death taxes due upon my wife's and my decease. Can you set out some basics on this?

Dear S.L.:

There are many successful people who have spent their lives accumulating substantial estates. Yet many of these people fail to realize that everything they own may be heavily taxed when they die. Furthermore, these taxes are generally due nine months after death and payable in cash.

In 1981, the Economic Recovery Tax Act (ERTA) created dramatic changes in estate tax planning. Among other things, ERTA established the unlimited marital deduction allowing passage of assets between spouses, in an unlimited amount, without federal estate or gift tax consequences. As a result, estate taxes can be postponed until the death of the surviving spouse. But that doesn't solve the problem--the tax bill eventually comes due.

Generally, there are four conventional ways for you to pay estate taxes and other estate settlement costs:

• pay cash;
• liquidate assets;
• borrow from a financial institution; or
• buy a life insurance policy.

The first alternative may be impractical because your most valuable assets, such as a business interest or real estate, may not be especially liquid. In fact, the first three alternatives tend to be costly, since they require, at the very least, the exact dollar amount of the estate tax. For example, if the estate tax liability is $1 million, it takes that amount, in cash, to pay the bill. Furthermore, by paying cash or liquidating assets, your heirs lose all growth and income these assets might have provided. Of course, borrowing the funds may be the most expensive method because it requires principal and interest be paid to the lender.

The fourth alternative, life insurance, is the one method where the amount paid has the potential to be a relatively small percentage of the benefit received. In other words, depending on your health and age and the performance of the life insurance policy, it's possible that over a period of years a total of $200,000 may be paid in premiums and a $1,000,000 death benefit may be available to fund the tax liability.

The cost of life insurance may be reduced even further, in some instances, by using a "second-to-die" or survivorship life insurance policy. These policies were created in response to ERTA and the unlimited marital deduction in order to provide needed liquidity to estates in a cost-effective manner. A second-to-die policy insures two individuals such as a husband and wife, under one policy. It pays a death benefit at the time the surviving spouse dies. This is frequently when liquidity is needed most because, under ERTA, much of the cost associated with estate taxes can be deferred until the death of the surviving spouse. A second-to-die policy may offer a significant reduction in insurance costs from a policy covering just one life because it doesn't pay the death benefit until both insured individuals have died.

Several types of second-to-die policies are available in the marketplace. Traditional whole life and universal life policies have been offered for years by a number of insurers. Variable second-to-die policies, which offer policyholders more investment control and growth potential than traditional policies, are recent additions to this marketplace.

Second-to-die life insurance may offer you a cost-effective solution to estate liquidity needs because it can help provide the funds to pay taxes for the estate, rather than from the estate.

Consulting with your legal and tax professional will help to ensure that the policy you purchase provides the benefits you intend.