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 Provided the policy has the proper structure, the heir pays taxes withdrawn funds at their own rate.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.

RELATED TERMS
  1. Life Insurance

    Life insurance is a contract in which the insurer guarantees ...
  2. Yearly Price Of Protection Method

    The yearly price of protection method determines the cost of ...
  3. Assessable Policy

    Assessable Policy is a type of insurance policy that may require ...
  4. Permanent Life Insurance

    Permanent life insurance refers to plans that do not expire, ...
  5. Insurance Premium

    An insurance premium is the amount of money that an individual ...
  6. Without Evidence of Insurability

    Without evidence of insurability refers to an insurance policy ...
Related Articles
  1. Insurance

    How to Avoid Taxation on Life Insurance Proceeds

    Decrease the value of your taxable estate and prevent the tax man from getting you one last time.
  2. Insurance

    Whole Life Insurance: A Gift That Grows

    The gift of whole life insurance may not be exciting for a child, but it could eventually help them pay for college or purchase their first home.
  3. Financial Advisor

    Buying a Life Insurance Policy? Read This First

    Knowing who needs life insurance, how it works and the different types of insurance can help consumers make informed decisions about this product.
  4. Insurance

    How Much Life Insurance Should You Carry?

    Before purchasing life insurance it is important to decide if you really need it, what type of policy is best, and how much coverage you should get.
  5. Insurance

    Life Insurance: How To Get the Most Out Of Your Policy

    There are many benefits to owning a life insurance policy - if you get the right one for you.
  6. Taxes

    Tax-Smart Ways To Help Your Kids/Grandkids Pay For College

    Learn about plans and accounts that allow you to efficiently save for your child or grandchild’s education while shielding the savings from the IRS as much as possible.
  7. Insurance

    What Is the Best Age to Get Life Insurance?

    Learn about the optimal time for purchasing personal life insurance and why delaying the buying decision may have costly consequences.
Trading Center