What is a Waterfall Concept

A waterfall concept is a life insurance plan that allows insurance holders to roll their policy over to a child or grandchild. 

BREAKING DOWN Waterfall Concept

A waterfall concept allows the child or grandchild of an individual with a tax-exempt whole-life insurance policy to receive the policy in a rollover transaction. Whole-life policies have two components. In addition to the death benefit that pays out when the insured passes away, whole-life policies also accumulate a tax-deferred cash value as the insured pays premiums. Eventually, the insured individual transfers the policy to a descendant, at which point the funds become taxable on withdrawal.

Passing on wealth using the waterfall concept falls under the category of estate planning. The process allows grandparents or parents to roll accumulated funds to a child while avoiding tax consequences at the time of the transfer. The child or grandchild pays taxes on the funds only when they withdraw them from the policy, and at their own effective tax rate. To the extent the original policyholder's tax rate exceeds the child's or grandchild's tax rate, the transfer continues to produce tax savings. 

Potential Pitfalls in the Waterfall Concept

The waterfall concept's use in estate planning depends upon maximizing the tax benefit of the transfer. The funds offer tax-deferred growth for the insured, so the impact remains negligible prior to transfer. The transfer tax place tax-free, avoiding pitfalls that can apply to gifts and other large-scale transfers of wealth. Provided the policy has the proper structure, the heir pays taxes withdrawn funds at their own rate. If the rollover takes place while the insured remains alive, the transfer does not go through the insured's estate. This avoids the pitfalls and costs associated with the probate process.

Attention to the structure of a policy using the waterfall concept can help to reduce risks involving the death of the policyholder prior to the transfer of the policy. The primary risk involves the passage of the policy into the insured's estate prior to rollover, subjecting it to the probate process. In situations where the insured intends to roll the policy over to a grandchild, for example, the policy may defer transfer until after the grandchild reaches the age of 18, using a contingent or irrevocable beneficiary, such as a parent, to pass the policy along and keep it out of probate should the insured pass away before the intended beneficiary comes of age. The insured can set the entire process up using the life insurance contract, obviating the need for the establishment of a trust or other legal entity in order to avoid probate.