What is 'Waterfall Concept'

A waterfall concept is a life insurance plan that provides a tax benefit in regards to intergenerational transfers of wealth. The concept occurs when someone rolls over their tax-exempt life insurance policy to a child or a grandchild. The term is derived from the idea that like a waterfall, this type of insurance plan only flows downwards.

BREAKING DOWN 'Waterfall Concept'

In a waterfall concept, the tax benefit occurs when the initial insurance policy is rolled over to the child or grandchild. After the transfer there are no more tax breaks, and any funds that are withdrawn from the policy are subject to normal tax liability. However, clients can implement different variations on the waterfall concept to meet different objectives.

Passing on wealth using the waterfall concept enables grandparents or parents to give funds to a child to use for college, a wedding or any other significant expenses. The child may also keep the policy in force if they want, avoiding possible insurability issues down the road.

Pros and Cons of Waterfall Concept

There are several advantages of using the waterfall concept to facilitate the intergenerational transfer of wealth. The transferor can provide a valuable gift and legacy for their child or grandchild and avoid annual taxation on the investment income generated on the gifted amount. They also avoid taxes when they transfer the funds to their heirs. And when the heir withdraws funds from the policy, as long as the transfer has been properly structured, the funds are taxable to the heir, not the transferor, at the heir's tax rate. The heirs can also avoid probate fees because the transfer doesn’t pass through the estate. A trusted individual can control the use of the funds in the transferor’s absence. This process can be enacted through the life insurance contract, without the need for legal intervention, which can save a considerable amount in legal fees.

There is some risk associated with the waterfall concept as an avenue for transferring wealth. For example, if the policyholder dies before the insured, the policy will become part of the deceased’s estate, and the gains in the policy will be taxable to the deceased. Probate fees may also apply. The larger the age difference between the policy owner and life insured, the greater the risk of this outcome. There are also risks associated with the loss of control of the policy once it is transferred to a beneficiary, for instance, if the beneficiary used the money in a manner that upsets the transferor.

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