1035 Exchange

  

Categories: Tax, Trading, Insurance

Why don't they give these things a name? Like what pathos is there in a number? It makes your life miserable remembering all of them—and frankly doesn't make our life any easier writing pithy epithets about 'em either. But here we go.

A 1035 exchange is a swap. More specifically, it's a swap relating to life insurance policies or annuities. You have one annuity or life insurance policy and want to exchange it with another one (of similar value), so you use a 1035 exchange to do it.

Why, you ask? Because a 1035 exchange is tax free. Taxxxx freeeee [insert Homer Simpson drool sound].

Related or Semi-related Video

Finance: What is Annuity?58 Views

00:00

finance a la shmoop. what is an annuity? a new it tea? maybe like you know the ones

00:10

that Instagram models advertise. yeah those. no it's not new. but the a new [picture of tea]

00:15

thing there at the beginning of the word no nothing to do with proctology. get

00:20

your head out of there. the ANU is short for annual- and that's the kind of you

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know derivative of the word there that applies. an annuity is a kind of weird

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insurance policy with hundreds of twists and flavors and special options

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investors can buy. let's say that the wonderful Cathy clueless invests a 100

00:39

grand in an annuity when she's 52 years old and she does nothing. from the way

00:44

the annuity contract is set up when she the investor turns 72 which is when she

00:49

plans to fully retire from her career as a professional interpretive dancer, she

00:53

can withdraw a thousand dollars a month for as long as she lives. so you think

00:58

hmm this is a weird shell game right? well she put in a hundred grand 20 years

01:02

earlier and now she gets a grand a month for as long as she lives. well how long

01:08

will she live? and what happened to that hundred grand ?it was that a good deal or

01:12

a bad deal ?well first things first the insurance company will likely have a [man frowns]

01:16

decent actuarial table to estimate how long interpretive dancers live. that is

01:22

they take data on factors like you know how often Cathy goes to CrossFit, whether

01:28

she engages in healthy habits like texting and driving, and you know the

01:32

food she eats and if she takes part in any dangerous activities like you know

01:36

skydiving. and well then they estimate and she lived to be 90 that is she'll

01:41

live 18 years after age 72 which is when she starts getting that grand a month or

01:46

eighteen times 12 and yes we're gonna ignore time value money here for a

01:50

moment. that equals 216 months of collecting a

01:54

grand a month from her annuity and you may think all those insurance companies

01:58

they're suckers. they made a bad deal. but then you look at their nice collection

02:03

of jets and buildings and your probably wrong yeah. well they only took

02:07

in a hundred grand and they have to pay out two hundred sixteen thousand dollars? [equation]

02:11

well yeah let's go back to the offices. there of fools gold insurance. do they

02:16

look like suckers no actually give suckers to buyers, but that's a different.

02:20

story so forensicly we go back to the original hundred grand that Kathy gave

02:25

to the insurance company. remember that rule of 72? yeah that one .will you take

02:29

the compound interest rate at which some investment grows, divided into 72 and

02:34

that's how long it takes to double. well the insurance company has historically

02:37

invested in a combo of stocks bonds real estate hedge funds and other things, such

02:41

that it gets about 7.2 percent a year return with a relatively safe portfolio.

02:46

so then if Kathy clueless invested 100 grand at age 52 ie handed over that [annuity math explained]

02:51

hundred grand to the insurance company so it's all theirs, yep then when we

02:55

divide that 7.2 into 72 and it's 10 meaning it takes 10 years

03:01

for that money to double. so it'll double by the time Cathy's 62 ,that hundred

03:08

grand goes to 200 grand when she's 62, and it still has another decade of

03:12

compounding before she even touches. it so let's do another rule of 72 doubling,

03:17

with that 7.2 thing in yeah that 200k has compounded again to double and be

03:22

worth 400 grand to the insurance company by the time Kathy is 72 and then begins

03:27

to withdraw cash, well to keep the math simpler let's forget the monthly numbers [ATM machine spits out money]

03:31

and just note that she takes out $12,000 a year now right? well that's 12 months

03:36

times a grand a month and well that 400 grand continues to compound again it's

03:41

7.2 percent. that is it grows in value in year 1 at about 29 grand. and the

03:48

insurance company only has to pay Kathy clueless $12,000 a year, so at the end of

03:53

year 1 her account is worth 429 K minus 12 K or about 417,000$. that is even

03:59

with a grand a month payout her account value grew and with compounding each

04:04

year it will grow more than it did the year before and she'll be withdrawing

04:09

way less money than the principal will have grown. if she lives to a hundred

04:13

fifteen the insurance company will still have done well because in this

04:16

particular policy they keep the money at the end.

04:19

now some policies have a life insurance kicker like had she died before she was

04:23

72 her grandkids would get a half a million dollar payout, or her original

04:28

hundred grand would be distributed to her heirs ,or the save-the-whales

04:31

foundation, or something like that. or there'd be some other twist and turn

04:34

that makes the annuity complex and hard to figure out from a mathematics

04:37

perspective for non professionals and the insurance biz. adding to the friction [woman is lost driving down the road]

04:41

is the fact that there are usually very high commissions and fees charged to

04:45

people like Cathy clueless. note her last name there. and they don't realize that

04:49

if they had just been disciplined and put that original hundred grand in an

04:54

index fund and forgotten about it well, they'd have come out vastly better than

04:58

buying that annuity. so why do people buy annuities in the first place? well why

05:02

did people invest in Enron and bad real estate in places and you know some

05:07

people just aren't financially literate enough to make wise decisions about

05:11

their future and they end up investing for retirement in an inefficient vehicle

05:15

like an annuity and you know talk about bad fuel economy and stuff like that. [ car smokes as it is driven]

05:20

they have good brokers though who really know how to make a commission selling

05:24

him maybe they should have watched this video right?

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