Life insurance can be pretty straightforward for many people, but the larger your estate the more likely you'll use life insurance for estate tax and business purposes. That's when things get complicated and mistakes are made. Here are some common mistakes to avoid.

Assume life insurance proceeds are free of tax. Yes, the beneficiary receives the proceeds free of income tax. But those same benefits may be subject to estate tax. Assume you have a $1 million estate, including your current life insurance. The first $675,000 is exempt from estate taxes unless you've reduced that exempted amount by making taxable lifetime gifts. The federal tax on the remaining $325,000 of your estate is $125,250. Assume you buy a life insurance policy for exactly that amount to cover the taxes. However, don't forget that the value of that life insurance policy ($125,250) will now be included in your estate, and you'll pay taxes on it-to the tune of an additional $51,353.

Fail to change ownership properly. One way to exclude life insurance proceeds from your estate and avoid the estate taxes is to change who owns the policy. For example, you might name your adult child as the owner and beneficiary of the policy, with you as the insured. Another common technique is to put the life insurance policy inside an irrevocable life insurance trust. But there are tax traps you must be careful of here. If you simply transfer ownership of the policy to the trust or your child, and you die within three years of the transfer, the proceeds are included in your estate. You can avoid that by having the child or trust buy the policy on your life. Whatever way you transfer ownership, you may have to deal with gift tax issues assuming you give money to the trust or your child to pay the premiums.

The main thing is to remember to change the ownership. In a recent court case, an insured had transferred a $1 million policy to a life insurance trust but failed to transfer ownership to the trust (he also died within three years of the transfer). The mistake cost the insured's heirs $450,000 in estate taxes that might have gone to them if things had been handled properly.

Misunderstand beneficiary implications. Simply having someone else own the policy can still cause problems. For example, a common mistake is to name the spouse the owner of the policy on the life of the other spouse, and then name the child (or life insurance trust) as beneficiary. When the insured dies and the proceeds pass to the child or trust, the surviving spouse is deemed to have made a gift of the full value of the proceeds, minus the $10,000 annual gift-tax exclusion if no other gifts were made in that year. That's a steep gift tax on a $500,000 or $1 million policy. Have the child or trust be both owner and beneficiary.

The same problem occurs with C corporations. Say a father buys a $2 million policy and has his C corporation pay the premiums. He names the company the owner and his son, also an owner in the company, the beneficiary. But when he dies and the proceeds are paid to the son, the proceeds are treated as dividends paid by the corporation, and thus taxed. Again, the son or an irrevocable life insurance trust should own the policy exclusively.

Instruct the life insurance trust. An irrevocable life insurance trust document that requires the trustee to use the life insurance proceeds to pay the estate taxes of the insured could bring the proceeds back into the estate and subject them to federal estate taxes.

Make improper exchanges. Increasingly popular are second-to-die policies. These policies pay upon the death of the surviving spouse, and their premiums are substantially less than separate policies for the same total amount. However, exchanges of a couple's separate life policies for a joint second-to-die policy don't qualify for tax-free exchanges, and any gains that have accrued in the original policies would become taxable income.

Fail to double check policy. Make sure the following mistakes are not part of your application: no contingent beneficiary, naming a minor as a direct beneficiary and misstating the date of birth of the insured. Also be sure your insurance agent understands the complexity of ownership and beneficiary rules.

This article was produced by the Consumer Affairs Dept. of The Financial Planning Association and provided to you courtesy of Nigel B. Taylor, CFP, Santa Monica, California. If you have any questions or concerns regarding this, or any other financial topic and are a resident of Southern California, please call me at 1-800-444-2237 (California residents only please), or click on the "MORE INFO" button to arrange for a free initial consultation in the comfort of your home or office.