What Is a Waterfall Concept?
Let me explain the waterfall concept directly to you: it's a straightforward estate planning strategy where you transfer a permanent life insurance policy from yourself, as the policyholder, to your child or grandchild.
Key Takeaways
You should know that the waterfall concept relies on whole-life insurance contracts to move wealth between generations in an efficient way. Remember, it only works for transferring from an older generation to a younger one, like a grandparent to a child or grandchild. Beyond the tax advantages, it also cuts down on probate complications and legal expenses.
How Waterfall Concepts Work
The main goal here is to pass wealth from one generation to the next while keeping taxes low. You achieve this by setting up a tax-exempt insurance policy, such as whole life, so that the child or grandchild can withdraw the tax-deferred cash value later, after you've passed away.
Whole-life policies come with two key parts: the death benefit that pays out upon death, and the cash value that builds up tax-deferred as you pay premiums. At some point, you transfer the policy to a descendant, and then the funds become taxable only when withdrawn.
On top of the tax perks, this approach sidesteps issues with gifts or large wealth transfers. You can handle it all through the insurance contract's terms, without needing expensive lawyers or middlemen.
Note on Probate
Using a waterfall concept to transfer wealth helps keep those assets out of probate, preventing them from being distributed to unintended parties.
Real World Example of a Waterfall Concept
Consider a common scenario: you transfer the policy from a grandparent to a grandchild. The grandchild pays taxes only on withdrawals, and if their tax rate is lower than yours, it saves money overall.
When setting this up, structure the policy to guard against the risk of dying before the transfer. One way is to name a third party, like the child's parent, as a contingent or irrevocable beneficiary, who then passes it to the grandchild when they're of age. You can outline all this in the insurance contract itself, no trust or extra legal setup required.
Is Whole Life Insurance Tax-Free?
The cash value in a whole life policy grows tax-deferred, meaning you owe no taxes while the money stays in the account. Unlike a savings account or CD, where earnings get taxed yearly, this setup lets beneficiaries withdraw at their potentially lower tax rate.
How Is Whole Life Insurance Different From Term Life Insurance?
Whole life gives you a guaranteed death benefit as long as the policy stays active, whereas term life only pays if you die within a set period, like 10 or 20 years. That's why term policies usually cost less than whole life ones.
How Much Does Whole Life Insurance Cost?
Costs depend on various factors, but whole-life policies can run you five to 15 times more than a term policy. For comparison, research shows an average term premium is around $30 per month.
The Bottom Line
In essence, the waterfall concept lets you transfer wealth to the next generation via whole life insurance by handing over the policy to a child or grandchild. This minimizes probate hassles and cuts taxes thanks to the tax-deferred cash value.
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