You need to know when an endowment can benefit you
Endowment policies have had a bad press because of high costs and lack of transparency, but newer-generation ones are more transparent and have lower costs, so it is worthwhile taking another look at them.
• If the endowment policy has a life assured (a person on whose death the invested amount is paid), it is possible to add a beneficiary. This has the advantage that on the death of the life assured, the policy pays directly to the beneficiary. This means that, although the policy is still an asset in the estate for estate duty purposes, the proceeds do not physically form part of the estate, and therefore avoid executor's fees. The proceeds can also pay out immediately to beneficiaries and avoid the delay of having to be wound up with the rest of the estate assets.
• Assuming you, as a natural person, own the policy, the life assurer through its policyholder fund will apply the following fixed tax rates: 30% on any income earned and 12% on any capital gains made. The life assurer will pay this tax on your behalf through what is known as the five-fund tax system, but the tax will be recovered from your portfolio. These tax rates are lower than the top marginal rates for individuals, which are 45% on income and 18% on capital gains. This means that if you are paying tax at the top marginal rate, you can potentially lower your tax rates by investing in an endowment policy. But take note of the issue of rebates under disadvantages.
• If you invest in funds through an investment platform and you switch between investments during the tax year, CGT will be payable. However, if you are invested in an endowment policy and you switch between underlying investments, this CGT will be paid from your portfolio. This means you won't face a cash flow problem.
• If you are invested in multiple unit trusts under the endowment wrapper, there are tax-compliance benefits. Normally, if you held these different investments personally, your tax return at tax year-end would be extremely complex and you would have to declare all the taxable interest, foreign dividends and any capital gains. That you hold all these units via the endowment wrapper makes your tax return much simpler, as all the tax is paid by the life assurer directly via its policyholder's fund and there is nothing for you as an individual to pay.
• Finally, and most importantly, in terms of the Long-Term Insurance Act, if the policy has life cover, and was effected by the insolvent on their own life or that of their spouse, and was in force for a minimum of three years prior to the date of an insolvency, such a policy would be protected against creditors. It's worth noting that the actual requirements of the act are complex and you should get more specialised advice to see if your specific case would qualify for protection.
• The tax rate for a policy held by you as an individual is fixed at 30% for income gains and 12% for capital gains. This means that if you have a lower tax rate than this, it would not make sense for you to invest via an endowment policy, as you would then be increasing your tax rate. I have often seen a parent wanting to take out an endowment policy for a child to start them investing. While the logic is good, an endowment policy makes no tax sense in this case - although there might be certain product benefits like premium waivers in the event of the parent's death or disability - as the child will have a lower tax rate than the endowment rate, and will therefore be better off investing directly via a unit trust.
• As an individual, you do not qualify for your tax rebates if you invest in an endowment policy, as you are not the taxpayer, the fund is. This means that you cannot make use of your R23 800 interest rebate - assuming you are under the age of 65 - or your annual R40 000 CGT exclusion.
You should be aware that these rebates will not be available to reduce the tax in your endowment portfolios and if you aren't using them for other investments, it is a missed opportunity to reduce your tax. You could, however, use these rebates for a unit trust investment.
• Finally, although companies have different products and different rules around loans, generally access to the money in an endowment is limited to one partial or full withdrawal in the first five-year period. The overall amount that can be taken is also limited by a formula. This issue is complex and you should discuss it with your financial adviser.
Benefits for high earners
An endowment policy has potential tax benefits, particularly if you are paying tax at the top marginal rate, and is a useful way to ensure proceeds are paid directly to beneficiaries and avoid the whole estate winding-up process. If your tax rate is lower than 30%, an endowment policy will not be tax efficient, nor will it be if you wish to make use of your tax rebates. The tax issues around investing in a particular wrapper are complex. An endowment policy might be the right vehicle for you, but it all depends on your personal and tax circumstances. Discuss these in detail with your financial adviser.
• Joffe is head of legal services at Discovery Life