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.
