Waterfall Concept: What It is, How It Works, Example

What Is a Waterfall Concept?

The term “waterfall concept” refers to a popular estate planning strategy in which a whole-life insurance policy is transferred, or “rolled over,” from the policyholder to their child or grandchild.

Key Takeaways

• The waterfall concept efficiently transfers wealth between generations using whole-life insurance contracts.
• It can only be used to transfer wealth from an older generation to a younger one, such as a grandparent giving to their child or grandchild.
• Waterfall concepts can also help reduce probate issues and legal costs, in addition to their tax benefits.

How Waterfall Concepts Work

The waterfall concept ensures that wealth is passed from one generation to another in a tax-efficient manner. It does so by structuring a tax-exempt whole-life insurance policy, allowing the child or grandchild to withdraw the tax-deferred cash value after the original policyholder’s death.

Whole-life policies have two components. In addition to the death benefit paid out when the insured passes away, these policies also accumulate a tax-deferred cash value as premiums are paid. Eventually, the insured transfers the policy to a descendant, at which point the funds become taxable upon withdrawal.

In addition to its tax advantages, the waterfall concept helps avoid pitfalls that can apply to gifts and large-scale transfers of wealth. For example, it can be carried out using only the terms and conditions of the original insurance contract, without the involvement of costly lawyers and intermediaries. Similarly, transferring wealth through a waterfall concept prevents those assets from being allocated to other parties during the probate process.

Real World Example of a Waterfall Concept

A typical example of the waterfall concept is the transfer of a policy from a grandparent to a grandchild. The grandchild pays taxes only when withdrawing funds from the policy, potentially resulting in overall tax savings if their tax rate is lower than that of their grandparent.

To protect against the risk of the original policyholder’s death before the policy is transferred, it is important to structure the policy appropriately. One method is to designate a third party, such as the child’s parent, as a contingent or irrevocable beneficiary, with the intention of transferring the policy to the grandchild once they come of age. This process can be stipulated using the terms of the life insurance contract itself, without the need for a trust or other legal entity.

To protect against the risk of the original policyholder’s death before the policy is transferred, it is important to structure the policy appropriately. One method is to designate a third party, such as the child’s parent, as a contingent or irrevocable beneficiary, with the intention of transferring the policy to the grandchild once they come of age. This can be stipulated using the terms of the life insurance contract itself, without the need for a trust or other legal entity.