You may have noticed that well-informed estate planners (usually the ones with all the money) tend to have their life insurance policies held in a trust. Heaven forbid that they would hold the policy in their own name and allow the government to snatch 35 percent (or more) of their family's planned death benefits because of estate taxes.

The rationale is simple for everyone who will one day be subject to the federal estate tax. If you are among them, it doesn't matter if you have a simple $100,000 term policy -- or an exotic million- dollar insurance plan. Either way, your family will pay a heavy price if you happen to own, or control, the policy at the time of your death.

For decades, the easy solution has been the life insurance trust. Under this approach, the prudent planner eliminates burdensome estate taxes by simply arranging for insurance policies to be owned and administered by an independent trust -- with a trustee of his or her own choosing. Nowadays however, this planning loophole is not so clear. Why, many ask, should somebody go to the bother of setting up a trust to save taxes when no one knows what the estate tax rules are going to be after the end of this year?

For example, let's say that Jack Q., a divorcee, is in the process of buying a $500,000 life insurance policy for the protective needs of his two minor children. Jack is reluctant to set up a trust at this time because he doesn't foresee any estate tax liability on the horizon. He knows that estates of his size (under $5.12 million) are untouchable by the IRS. However, he also knows that the rules might tighten up after 12/31/12. This could potentially lead to a huge estate tax burden for his kids down the road.

What to do? Should Jack form a tax-saving trust now and be on the safe side -- or should he just buy his insurance policy with the expectation that he could always form a trust later if it's needed? This kind of question, understandably, has become a quandary for all concerned planners who are trying to deal with an unpredictable tax code and an erratic economy.

In Jack's case, his adviser might tell him to go ahead and lock in the insurance protection that is needed for the kids right away. This is with the understanding that he could set up a trust later if needed. After all, no one says that you can't transfer ownership of your insurance policy to a trust any time you please.

Sounds like good advice. But if YOU happen to need life insurance protection and you can't decide if you're ready for a trust, there are few pre-cautionary notes that you should keep in mind.

Caution No. 1 -- The Three-Year Rule. There could be a small risk associated with the wait-and-see approach, and it works like this. If Jack were to die within three years AFTER transferring ownership of his policy, the entire $500,000 proceeds will wind up being taxed in his estate. That's right, when planners (such as Jack) don't live at least three years after they transfer a life insurance policy to a trust, all their efforts will be for naught. In Jack's case, however, because of his young age and good health; he and his adviser agreed that "wait-and-see" is a risk worth taking.

Caution No. 2 -- Be wary of the tax rules in the state in which you live. -- Estate planners have become notably indifferent about the need to form a life insurance trust or -- for that matter -- to take any active steps to minimize their estate tax burden. They have a sense that the IRS will continue with the generous lifetime exemptions and, also, that the value of their assets will never exceed the exemption amount, whatever that may be.

However, it needs to be emphasized that many states don't follow the federal rules. Maryland, for example, has a lifetime exemption of only $1 million, and it has no plans to change its estate rules anytime soon. That could mean one thing for many Maryland residents who don't have an action plan in place. One day their children might be wishing that the insurance benefits that they received had gone through a (tax-free) life insurance trust -- rather than to them directly.

In summary -- Any insurance policies that you own could add a major tax cost on the very estate that you are trying to protect for your family and loved ones. When talking to your tax adviser at this transitional time, ask about any tax risks that you might have with the insurance policies that you own -- or plan to buy. Then, get a clear estimate of what the costs would be for you to set up a trust in order to eliminate unnecessary taxes once and for all.

Thomas J. Stemmy of Annapolis is an award-winning author and partner with Stemmy, Tidler & Morris in Greenbelt. He is the author of "Top Tax Saving Ideas for Today's Small Business." email him at TStemmyCPA@yahoo.com.