In this series, we will look at popular tools used for better financial management.  With a particular focus on those which help curb taxes. We’ve assessed how well they work, noted when it is best to use them and debunked some misconceptions about them.

First, we will take a deep dive into endowment policies. There has been an uptick in the use of these vehicles in the recent past. But there is some debate about the tax efficiency of these policies. We do believe there is reason to use endowments in certain cases. Here, we unpack why and when you should consider them.


What is an endowment?

An endowment is essentially a life insurance policy that covers the life of the insured.  It helps the policyholder save money for the future. This can be done with a single investment or regular contributions. It is best seen as a long-term investment of at least 5 years.

Many investors believe these vehicles are tax-free. This perception is created because the proceeds of the policies are paid net of tax to investors. Investors are not liable for tax on the policies, but the life insurance companies are.


Are endowments tax efficient for individuals?

Tax within an endowment structure is paid by the life insurance company. Current tax rates for individuals are set at 30% on all income and 12% on capital gains made. Individuals are taxed on their taxable income (earnings, interest income, rental income and any other form of income received) - up to 45% on income and 18% on capital gains.  This is done on a sliding scale. To establish when an endowment makes sense, you need to establish the effective tax rate paid by individuals.

Someone who earns R1.2 million per year with no retirement savings will pay an effective tax rate of 30% on their income. On a pure comparison basis for tax, you should only invest into an endowment if your taxable income is higher than R1.2 million. Anyone else ends up paying more tax within the structure than in their personal name.

If you contribute to a company pension fund or retirement annuity, you should remember that these contributions are deducted from taxable income. Should you earn R1.5 million and contribute 20% to a pension fund your taxable income is still only R1.2 million.

Now, if you are earning more than R1.2 million, you need to decide why you are investing the money. Is it a long-term investment to supplement your retirement income? And will you continue drawing more than R1.2 million during your retirement years? If so, remember that this is when most of your taxes are paid. As you start drawing an income from investments the tax you pay increases as you are also liable for capital gains taxes on withdrawals.

Endowments might be a tax efficient vehicle for some, but we do not believe it is a one-size fits all approach. The admin burden of paying tax may be less but the overall tax might be a lot more than you realize.


Should you use an endowment for estate planning purposes?

An endowment allows the policyholder to nominate beneficiaries for proceeds on the policy, much as a life policy does. Currently, the Master’s office is taking years to wind up estates.  If you leave a spouse with few investments in his/her name, it’s worth considering.

Further, it is free from executor’s fees. You will still be liable for estate duty but you skip out on the legal fees.

We believe these factors make it worth considering. For long-term estate planning, it is worth investing funds in both spouses’ names early on. This helps reduce the amount of tax you’d pay on future withdrawals, as tax liability will be split between two people. It also reduces the risk of leaving a spouse behind with no investments in their name for short-term needs.

Executor’s fees can be as much as 4.025% of your estate. Have you considered negotiating this fee with your lawyers in your will? It is an option and something you can do during your lifetime, especially as your estate grows. It is cost-effective planning but is best considered alongside your tax planning. The capital gain within the endowment will be taxed at 12% on transfer of assets. You might be in a position where you pay less which nullifies the cost saving on executor’s fees.


When would we use endowments?

We use endowments in very specific circumstances. We recommend endowments when taxable income is well above R1.2 million per year and we see this need continuing during retirement. This is quite rare for retirees. We also look at it if there are specific estate planning elements that justify a seamless transfer of assets to a spouse or beneficiary. Endowments are only used for estate planning if those options listed above have been exhausted.  We also look at the need for protection against creditors in a situation where insolvency is a risk. This would be specific to business owners or people married in community of property. These factors are considered with a client’s overall picture in mind. 

Globally, we prefer holding share portfolios within an endowment structure.  Doing so protects the investor against death taxes in the United Kingdom and United States listed in these jurisdictions (known as SITUS assets).

We also use global endowments as they allow for the seamless transfer of assets to beneficiaries.  You don’t need an offshore will which means you don’t have to wait for the Master’s office in South Africa.

In closing, an endowment policy is not a one-size fits all approach and should not be sold as such. It should be carefully considered, taking your specific needs and circumstances into account.  It should only be used if it makes sense.


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