Having enough life and disability insurance should be a key element of your personal financial game plan.

Since most of just finished filing our annual income tax return, we may not be in the mood to further discuss the topic of taxes … unless it’s all about avoiding them. Which is why now is a good time to turn to the topic of life insurance, taxes and your estate plan.

The primary purpose of life insurance, for most people, is to replace income that would be lost should you die prematurely. The good news is that life insurance death benefits are generally received by your beneficiaries free of any federal income tax (and usually free of any state income tax as well).

But what about the federal estate tax? Contrary to popular belief, the death benefit of life insurance could be subject to estate tax. If the tax rules treat you as the owner of a policy on your own life, the death benefit is included in your taxable estate – unless the money goes to your surviving spouse (they then will become part of his or her estate). If you are the owner of the policy and the death benefits go to anyone else, a child or sibling even, then money is included in your estate.

The estate tax exemption is currently set at $5 million through 2012, and although this is historically quite high, a large life insurance policy could push an otherwise non-taxable estate above the limit. And don’t forget that the current rule is in place only through 2012, and there are quite a few who believe lowering the exemption might be the answer to reducing our federal debt.

Smart Money last week laid out pretty clearly how the life insurance / estate tax scenario plays out. To quote them: “The tax rules say you own a life insurance policy if you possess so-called ‘incidents of ownership.’ You have them if you retain the power to change policy beneficiaries, change coverage amounts, cancel the policy and so forth.”

So, how do you avoid these “incidents of ownership”? You can establish an irrevocable life insurance trust (ILIT) to purchase a new policy on your life. If that’s not possible, you could consider transferring an existing policy. But there are some potential land mines in that strategy. First, if you transfer the policy and die within three years, the IRS pulls the proceeds back into your estate as if the transfer had not occurred. Second, if you transfer a policy with cash value in excess of $13,000, it could trigger adverse gift tax consequences.

You can read more about trusts on our website. While you’re there, be sure to sign up for our free estate planning e-newsletter to stay informed of important matters affecting your estate plan.