# Waterfall Concept: What It is, How It Works, Example

![Waterfall Concept: Using a tax-exempt permanent life insurance policy to efficiently transfer wealth between generations. ](https://www.investopedia.com/thmb/_88Ts_Ne61IHPxe0y_5Vy6A6HMk=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Waterfall-Concept-final-02f5dc1c4af4487d97a63b1b18ff0883.png)

*As well as enabling tax advantaged intergenerational wealth transfers, the waterfall concept also helps avoid other pitfalls that can apply to large scale wealth transfers. — Investopedia / Zoe Hansen*

> **Definition**
>
> The waterfall concept is an estate planning strategy that uses whole-life insurance contracts to transfer wealth between generations. It's an efficient transfer of funds since it includes tax benefits and can minimize probate issues and legal costs. For example, a grandparent giving their child or grandchild a whole life insurance policy transfers wealth that accumulates tax-deferred value.

## What Is a Waterfall Concept?

The waterfall concept is a popular [estate planning](https://www.investopedia.com/terms/e/estateplanning.asp) strategy in which a [permanent life insurance](https://www.investopedia.com/articles/pf/07/permanent_life_insurance_taxes.asp) 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 using life insurance to transfer wealth from one generation to the next.
*   It ensures tax-efficient wealth transfer, often benefiting younger generations with potentially lower tax rates.
*   By utilizing existing insurance contracts, the waterfall strategy can reduce legal costs and avoid probate issues.
*   The concept involves transferring a whole life insurance policy, which accumulates tax-deferred cash value, to descendants.
*   Successful execution requires careful planning, such as designating contingent beneficiaries to ensure smooth transfers.

## How the Waterfall Concept Facilitates Tax-Efficient Wealth Transfer

The purpose of the waterfall concept is to ensure that wealth is passed on from one generation to another in a [tax-efficient](https://www.investopedia.com/terms/t/tax-efficiency.asp) manner. It does so by structuring a tax-exempt insurance policy, such as [whole life](https://www.investopedia.com/terms/w/wholelife.asp) in a manner that permits its tax-deferred cash value to be withdrawn by the child or grandchild at a future date, after the original policyholder has died.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 parts: a [death benefit](https://www.investopedia.com/terms/d/deathbenefit.asp) paid upon the insured's death and a cash value that grows tax-deferred as premiums are paid. Eventually, the insured individual transfers the life insurance policy to a descendant, at which point the funds become taxable on withdrawal.

Besides tax benefits, the waterfall concept can prevent common issues with large gifts and wealth transfers. Waterfall concepts can be executed through the insurance contract terms alone, avoiding expensive lawyers and intermediaries.

### Note

[Transferring wealth through a waterfall concept](https://www.investopedia.com/articles/financial-advisors/111215/why-wealthy-should-buy-lots-life-insurance.asp) can help prevent those assets from being allocated to other parties as part of the [probate process](https://www.investopedia.com/articles/04/121304.asp).

## Real-World Application: Waterfall Concept in Action

A typical example of the waterfall concept would be one in which the policy is transferred from a grandparent to a grandchild. The grandchild pays taxes only upon withdrawing funds, potentially saving on taxes if their rate is lower than the grandparent's.

The policy should be structured to protect against the original policyholder dying before the transfer. Designate a third party, like the child's parent, as a beneficiary to ensure the policy transfers to the grandchild when they reach adulthood. This can be outlined in the insurance contract without needing a [trust](https://www.investopedia.com/terms/t/trust.asp) or legal entity.

## Is Whole Life Insurance Tax-Free?

The cash value of a whole life insurance policy is tax-deferred, which means no taxes are owed as long as the money remains in the account. A [savings account](https://www.investopedia.com/best-high-yield-savings-accounts-4770633) or [certificate of deposit](https://www.investopedia.com/best-cd-rates-4770214), by contrast, would have earnings that are taxed annually. If beneficiaries pay taxes at a lower rate than the policyholder, withdrawals could be made at that lower tax rate.

## How Is Whole Life Insurance Different From Term Life Insurance?

Whole life insurance provides a guaranteed death benefit as long as the policy is current, while term life insurance provides a death benefit only if the insured dies within a specified period of time, such as 10 years or 20 years. Because of this difference, term policies typically cost less than whole policies.

## How Much Does Whole Life Insurance Cost?

Costs can vary depending on several factors, but whole-life policies typically can cost as much as five to 15 times as much as a term policy. And for a term policy, [Investopedia research](https://www.investopedia.com/term-life-vs-whole-life-5075430) shows that an average premium is about $30 per month.

## Key Benefits of Using the Waterfall Concept for Estate Planning

The waterfall concept is a means of transferring wealth from one generation to a subsequent generation by using whole life insurance. In this strategy, the insurance policy is transferred from the policyholder to a child or grandchild. This can reduce probate issues and ultimately reduce taxes since the cash value of the insurance policy is tax-deferred.

> **Article Sources**
>
> 1.  National Association of Insurance Commissioners. "[Life Insurance](https://content.naic.org/cipr_topics/topic_life_insurance.htm)." Accessed March 18, 2021.
>     
> 2.  Internal Revenue Service. "[Estate Tax](https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax)." Accessed March 18, 2021.