High-income earners should look twice before sidestepping endowments – Moneyweb.co.za

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Over the past few years endowments really took the back stage with the emergence of different and more exciting investment options. Not so any longer, recent tax changes put a definite sparkle in the new generation endowments. Especially for those consumers in the top tax brackets who want to lighten their tax burden.

Endowments can be very effective tax arbitrage vehicles in a larger investment portfolio. The income proceeds in endowments are taxed at 30%, which means that if your marginal tax rate is greater than 30%, your returns will be taxed at a lower rate. *

This is significant in an environment with recent tax changes such as the increase in dividend withholding tax to 20% and the new 45% tax bracket for those who have an annual income of above R1,5 million. Investors are forced to make smarter decisions to improve their long-term investment returns. 

Another consideration for long term investors is the effect of Capital Gains Tax (CGT) on the investment. Endowments are taxed at an effective rate of 12% for capital gains, compared to the maximum effective CGT rate which has moved from 16.3% in 2016 to 18% in 2018.  If it is your family trust investing that’s a whopping 36% of your profit gone. 

Even more concerning is the trend in the taxable gain of the inclusion rates of the profit and the maximum effective tax rate. There are tax experts predicting 100% inclusion rates for the CGT calculations. 

Inclusion rates and effective rates

 

Inclusion Rate

Maximum Effective Rate

 

2016     2017     2018

2016     2017    2018

Individuals

33,3%   40,0%   40,0%

13,7%   16,4%    18,0%  

Special Trusts

33,3%   40,0%   40,0%

13,7%   16,4%    18,0%  

Companies

66,6%   80,0%   80,0%

18,7%   22,4%     22,4%

Trusts

66,6%   80,0%    80,0%

27,3%   32,8%     36,0%  

Endowments policies have a contract period of anything from five to 15 years. You can choose to make a lump sum investment or recurring contributions and select the underlying assets. These days you can even include a share portfolio in your endowment. 

Generally, the new generation products allow you to switch freely between the assets at any point during the investment period. 

The investment returns come from the underlying assets. Depending on these you may be liable for CGT. The tax administration is taken care of as returns are taxed in the hands of the insurer who pays the tax on the investors’ behalf.

A negative for many investors is still that fund withdrawals of endowments are restricted to your contributions plus 5%, for the first five years. Others view it as a disciplined form of saving.

Most of the new endowment products have the option though of a once-off limited withdrawal and an interest-free loan facility within the first five years. After five years you usually may withdraw at any time, or schedule regular withdrawals.

You can also have the endowment “open ended” with a minimum term, such as five years. Then there are no limitations to what you may contribute or withdraw from the endowment, while getting the tax benefits of the investment.

Endowments can be efficient tools for estate planning purposes. Your beneficiaries will receive your investment immediately and no executor’s fees will be paid on this amount. The proceeds from the endowment will, however, form part of the estate for estate duty purposes.

Endowments can also be considered for trusts, where the beneficiaries are individuals, as the tax rate on trusts (excluding special trusts) has been increased to 45% and the effective capital gains tax rate to 36%. Endowments are taxed at a flat rate of 30% for individuals and trusts and at 12% for capital gains. If the trust invests in a share portfolio through an endowment, it can reduce the tax payable on your investment growth.

Not all endowments are equal – be aware that those offered by life companies do not offer the same flexibility and there are often hidden and layered costs involved. 

*Remember, endowments will not be the most tax efficient choice if you are taxed at less than 30%.

Janet Hugo is director of Sterling Private Clients and a Certified Financial Planner

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