What I love about our vibrant financial services industry is all the choice we have when it comes to investing and investment products, and when used wisely these can help one become financially free!
One of the relatively unappreciated and often forgotten investments out there with wonderful estate planning and taxation advantages is the humble little endowment.
When I first started my career in the financial services industry almost 20 years ago, the first experience I had with an endowment policy was unpleasant at best. At the time these were relatively complicated and misunderstood structures and mainly sold as “education policies”. These products generally had a life cover element attached, were largely underperforming due to high costs and fees and were not being effectively used in the construction of a solid financial plan.
Basically back in the day endowments had a bit of a bad reputation among investors!
Twenty years on I am happy to see how these products have been cleaned up and evolved into fantastic structures, saving investors a ton in tax and ensuring that their beneficiaries are not left high and dry in the event of the investors’ death.
Endowments have an important place and role to play in your financial plan. In fact everyone should consider including an endowment in their financial plan (portfolio) at some point.
So what is an endowment?
An endowment is a type of investment policy issued by a life insurance company, like OUTsurance Life Insurance Company. All endowments have a minimum investment period, known as a restriction period that requires you to stay invested for a period of 5 years. During the restriction period it is not advantageous to access your money due to the heavy penalties involved.
In theory, an endowment can invest in a range of options, for example shares on a stock exchange, debentures, bonds, cash or even a fixed deposit.
What makes an endowment different to other investments is that the return (proceeds) investors receive after the 5 year restriction period is after all taxes and fees have been deducted. The life insurance company pays tax on the money and not you.
When does it make sense to use an endowment?
Endowments are excellent investment products offering advantageous estate planning and tax advantages.
Currently (according to tax law) interest earned within an endowment policy is taxed at 30% (no interest exemptions apply as they do to individuals) and paid to the Receiver of Revenue. Therefore, if ones marginal personal income tax rate is higher than 30% then endowment investments become attractive. It effectively caps the amount of tax that you pay on interest in your investment to 30%
The rate of Capital Gains Tax (CGT) applicable is also lower in an endowment structure. Currently CGT inclusion means that individuals in the highest tax bracket have an effective CGT tax rate of 18%, in an endowment the effective CGT rate for those individuals would be 12%
Estate planning advantages:
Beneficiaries don’t need to wait for the estate of the life assured to be wound up (which could take up to a year or even longer) to access money from the endowment. As a result your beneficiaries have access to money quickly in the event of your death to help them get by while the estate is being wound up
Because the proceeds from an endowment will be paid directly to beneficiaries no executors’ fees are payable – thus a saving of as much as 4%
Other practical advantages:
- Simplified tax administration as the life company does all the work.
- You can cede an endowment policy as security for a loan.
- Insolvency protection after a three year period is possible provided certain criteria are met
- Endowments are handy investments that can be harnessed to supplement your income and reduce tax liability at retirement if used smartly
Where does an endowment fit in a good financial plan?
Compulsory and Discretionary Investing
Any good financial plan essentially has two elements, Compulsory and Discretionary Investments. Compulsory Investments are retirement funds like Pension, Provident, Retirement Annuities and Preservation funds, while Discretionary Investments cover a wider range of investment options (choice), for example unit trusts, property, gold, shares.
Compulsory Investments are generally subject to more onerous legislative constrains and requirements (like liquidity, investment restrictions (regulation 28), access to funds, flexibility etc.), while Discretionary Investments are less onerous, more flexible and offer wider investment options and choice than Compulsory Investments.
Endowments can be classified as Discretionary Investments and when used smartly can save you tax, enhance your retirement planning and provide for your beneficiaries.
When does using an endowment make sense?
In a nutshell, if investors have utilised their annual interest and capital gains tax exemptions, contributed their maximum annual amount to a tax free saving account and have a 30% or higher marginal tax rate, endowments start making sense and offer good value.
An Endowments’ place among your discretionary investments
When it comes to deciding where and when to use an endowment as part of your discretionary investment mix consider the following five steps:
A good financial plan starts with a good emergency fund. Set up an Emergency Fund by using a Money Market investment like a unit trust. A portion or full amount of the annual tax interest exemption can be used. Currently if you are under 65 years old you can earn R 23 800 interest (cumulative from all interest generating investments) without having to pay tax and R 34 500 if you are older than 65
Once your Emergency Fund is in place and you still have not utilised your full annual interest exemption consider investing in another Money Market unit trust to use your remaining interest exemption. Do not use this unit trust for emergencies but rather for longer term investing
Invest and contribute your maximum annual allowance (currently R 33 000) to a Tax Free Saving Account, like the OUTvest Tax Free Plan
Invest in some voluntary investments like unit trusts (OUTvest Voluntary Plan) until you have surpassed the annual Capital Gains Tax (CGT) exemption. Currently the first R 40 000 in capital gains that you withdraw cumulatively from all your investments that attract capital gains tax (CGT) in a tax year, is free from paying tax
Then consider an endowment investment. The first prize is to find an endowment where the life insurer has a tax loss that can be used to reduce the tax payable within the endowment, like the Fixed OUTcome Endowment.
What makes our Fixed OUTcome Endowment different to other endowments?
OUTsurance Life (the life insurance company) has a deferred tax asset that it has built up that it can use to give investors a higher after tax return on their investments. Thus, while OUTsurance Life still has a tax asset that it can utilise, no tax is paid in the Fixed OUTcome Endowment like in other traditional endowments, which means more of your money working for you. Click here to view some of the benefits.
When it comes to investing and deciding on whether an endowment is best for you it is always prudent to seek proper financial advice. As part of our investment processes, OUTvest will help you decide whether an endowment is the right investment for you. Click here to find out more.
Gareth van Deventer CFP®
OUTvest: Head of Advice Centre
0860 688 837
OUTvest is an Authorised FSP. All tax figures shown in this article are subject to change. Although we have tried to set out some key information to consider, we are not tax professionals and we suggest you speak to your tax consultant for any advice on your personal tax.