What is a Waterfall Concept?

A waterfall concept in a clause or strategy used in life insurance policies that allow the child or grandchild of the policyholder to enjoy the policy. The waterfall concept means that a life insurance policy can rollover or be passed on by the policyholder to their child or grandchild. A waterfall concept is commonly used in real estate, the child or grandchild inherits the policy.

How Does a Waterfall Concept Work?

The whole-life insurance policy that is passed to a child or grandchild by a policyholder using the waterfall concept is tax exempt. All the clauses or terms of the policy rollover to the beneficiary. In most cases, the policy is inherited by the beneficiary when the policyholder dies, all the dividends that the policy has accrued overtime are also passed down, to the child or grandchild. When transferring the insurance policy, tax consequences are hedged but at the point of withdrawal, the funds are taxable. At the time of withdrawal, the effective tax rate of the descendant (child or grandchild) is used when calculating the tax.

Potential Pitfalls in the Waterfall Concept

Despite that the waterfall concept seems like a good strategy, there are certain downsides. One of the pitfalls is the payment of taxes by the descendant upon withdrawal from the policy. The structure of the policy is quite important in the avoidance of the downsides that are attributable to a waterfall concept. If a policyholder dies before the policy is transferred to the descendant, there are many risks than when transferred when the policyholder is still alive. A trust must be established to guarantee the right of a descendant to the policy, this would help in mitigating risks such as undergoing probate process.