What Is a Waterfall Concept?

The term “waterfall concept” refers to a popular estate planning strategy in which a whole-life insurance policy is transfered一or “rolled over”一from the policyholder to their child or grandchild.

Key Takeaways

  • The waterfall concept is an estate planning strategy that uses whole-life insurance contracts to efficiently transfer wealth between generations.
  • It can only be used to transfer wealth from an older generation to a younger one, such as in the case of a grandparent giving to their child or grandchild.
  • In addition to their tax benefits, waterfall concepts can also help reduce probate issues and legal costs.

How Waterfall Concepts Work

The purpose of the waterfall concept is to ensure that wealth is passed on from one generation to another in as tax-efficient a manner as possible. It does so by structuring a tax-exempt whole-life insurance policy in a manner that permits its tax-deferred cash value to be withdrawn by the child or grandchild at a future date, after the original policyholder has died.

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.

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

Real World Example of a Waterfall Concept

A typical example of the waterfall concept would be one in which the policy is transferred from a grandparent to a grandchild. The grandchild would then pay taxes only when withdrawing funds from the policy. To the extent that the grandchild’s tax rate is lower than that of their grandparent, this would result in tax savings overall.

When using the waterfall concept, it is important to structure the policy in a manner that protects against the risk that the original policyholder might die before the policy is transferred. One method to do so is by designating a third party, such as the child’s parent, as a contingent or irrevocable beneficiary, with the intention that the parent would then transfer the policy to the grandchild once he or she comes of age. This process could be entirely stipulated using the terms of the life insurance contract itself, without requiring the use of a trust or other such legal entity.