Sponge Policies Can Soak Up Assets In A Tax-Advantaged Way

The recently enacted Economic Growth and Tax Relief Reconciliation Act calls for an estate tax phaseout and eventual repeal–until, that is, the Act itself expires.

Fortunately, there is a workaround for some of the issues that uncertainty raises. It comes in the form of a specially structured life insurance policy. More on that later. First, lets review the current climate.

As things now stand, there will be no estate tax in the decade to come–unless, of course, there is one.

Confused? Imagine how your clients feel. Not only must they plan for death, but they must also plan for ever-changing political winds.

Life insurance policies and trusts are already springing up to address this uncertainty. They are doing this in various ways, such as allowing refunds and reversions back to the grantors who, as it will perhaps turn out, never needed to grant the coverage or product at all.

But even these creatively crafted instruments fall short of the mark in their attempt to reimburse the client, particularly when a gift tax has already been paid. In addition, because they entail new and untested ideas, they will no doubt have to withstand challenges by the Internal Revenue Service, not to mention state tax authorities.

The bottom line is: Your clients need more than one reason to buy life insurance. The possibility of having to pay an estate tax that is not even called for under current law probably wont cut it.

But what if you could offer big income tax savings today and the possibility of big estate tax savings later?

Better yet, what if your clients could avoid making any irrevocable gifts for the next two presidential elections, and then only do so if needed? (Thats an important question for some of your clients, because the days of irrevocable gifting are over, forever eclipsed by the sunset provisions of the Tax Relief Act.)

Interestingly enough, the solution to todays problem may very well lie in a relatively old life insurance conceptthe so-called “sponge” policies.

Sponge contracts have been around for over a decade, and are used by highly sophisticated financial planners to transfer assets at a discount. The ideal contracts for this purpose are life insurance policies that have low cash surrender values in the early years as well as discounted reserve values.

The theory is simple. Use the policy to “soak up” the assets you want to movesuch as assets in a 401(k) or a profit-sharing plan. You do this by using the targeted assets to fund large life insurance premiums that pay for the policy over a short period of time. After these assets have been “soaked up,” the policyowner transfers the contract and pays taxes on the value of the policy.

If the policy value is less than the sum of the premiums absorbed, the client will have received a tax advantage due to this arrangement.

Most often, sponge policies are used inside qualified plans as a means of transferring pre-tax assets. Individual Retirement Accounts are particularly popular for this purpose; they are typically rolled over into newly established profit-sharing plans to allow for the purchase of the life insurance. Several years later, the policy is distributed or sold from the plan for its discounted value, thereby saving income taxes. Soon thereafter (or even simultaneously), the policy is transferred out of the estate, saving gift taxes as well.

Heres the point. The policy is generally not distributed from the plan or transferred from the estate for at least three years, and perhaps as long as six or seven.

That gives the client time to assess political changes and determine whether or not to make that final irrevocable transfer. If it becomes clear that the Act will be re-enacted and the estate tax repeal made permanent, then the policy need only be distributed from the plan, resulting in significant income tax savings. Since no additional benefit will be derived from gifting, no gift will ever occur.

If the appropriate product is used, and if the proper procedures are followed, the transaction should fit well within the letter and spirit of the federal tax code.

However, if you are not familiar with these techniques, please be careful. Not every policy carries a discounted value. In addition, the value of a policy may depend upon the circumstances of the transfer. Work only with experienced program providers and avoid such contrivances as:

Springing cash surrender values.

Large death benefits that suddenly drop.

Policies that are “paid-up” before being transferred.

Universal life policies that morph into variable ones.

Look for a fair trade-off between liquidity and discounts. The client should be willing to give up access to the cash value for a fairly lengthy period of time.

And, as always, heed this time-honored caution: If the deal looks too good to be true, it probably is.

Robert K. Strauss, J.D., is co-chairman of Emerging Money Corporation, Stamford, Conn. You can e-mail him at bob@familydiscountlife.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, July 20, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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