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If the proposed changes in the estate tax laws are adopted by congress, and it looks like they will be, the exemption limits will finally be sufficiently high enough to protect the majority of John McCain’s middle class from having the pants taxed off of their estates.

If all goes well, in 2009 the individual estate tax exemption will be raised to $3.5 million, up from just $600,000 8 years ago. This means that a married couple can effectively exempt the first $7 million of their estate from the proposed 45% tax.

If you try to go it alone in estate planning and purchase life insurance to cover taxes that may come due upon your death or the death of you and your spouse, you may make a simple error that will result in creating a larger tax liability rather than providing the funds to dispose of the liability that exists. The mistake is the ownership of the life insurance.

If an estate isn’t in a taxable situation and isn’t likely to be, there isn’t anything wrong with being the owner of your own life insurance policy. In fact it makes sense in most cases. But, if you own your own policy, while the proceeds are not taxable as income to your beneficiaries, the amount of the death benefit is added to your estate. So, if you had an estate worth $5 million and you owned a life insurance policy on yourself for $5 million, upon your death your estate would have a value of $10 million. Instead of $1.5 million being taxable after the exemption, there would be $6.5 million taxable at a rate of 45%.

The key is ownership and when you’re dealing with estate value and taxation the most prudent route to take is setting up an irrevocable life insurance trust that owns and is the beneficiary of the policy. This keeps the proceeds from being added to the worth of the estate and lowers the tax burden, allowing all of the life insurance to pass freely to the task of paying estate taxes.

So, if you own your own policy, can you just set up a trust and do an ownership change? Well, the answer is yes, sort of. The IRS has a 3 year look back rule when it comes to life insurance ownership and if the ownership has changed in the 3 years just previous to a person’s death, they will rule that the original ownership stands. While most of us can suck it up and say we’ll just outlive that 3 year rule, if there is anything substantial on the line, it may be prudent to buy a short term insurance policy owned by the trust that can cover the three year rule as it runs its’ course.

Bottom line. Good estate planning and guidance is worth the expense. Just one word of caution. Pass on to your estate planner or attorney that you’ve heard that people occasionally die prematurely so it would be best if they could make a recommendation on what life insurance to purchase and how without making a career out of it.