Photo by Sven Mieke
In our previous blog post, we encouraged you to begin the year by evaluating your Financial Gym Strategy.
We encouraged you to push yourself to do some heavy lifting by increasing the amount you are investing.
We also began a three-part series talking about three typical investment options: Tax-Free Savings Plans (TFSAs), Endowments and Retirement Annuities.
In this post, we focus on Endowments which are not often discussed as investment or savings options.
What are Endowments?
Simply put, endowments, designed to help individuals, are long-term (5 years or more) investment policies offered by life insurance companies. They are especially suited for those in higher tax brackets due to their unique tax structure and estate planning benefits.
Key Features
Fixed Minimum Term: Endowments have a minimum term of five years. During this period, you are allowed only one withdrawal and one (interest free) loan. Early termination may attract penalties, encouraging disciplined savings. There is no fixed maximum term. Terms longer than five years can be structured to align with longer-term investment goals.
Contributions: You make regular monthly contributions or a lump-sum payment, and the life insurance company invests these funds on your behalf into your chosen funds/assets based on your investment risk profile.
There is no limit to contributions (lump sum or monthly) in year one. In year 2 additional contributions are limited to 120% of the year 1 contributions. If additional contributions exceed 120%, then the fixed minimum term to payout/maturity term of 5-years resets. Therefore, it is important to carefully decide on the investment amount in year 1 and then stay within the annual contribution limits thereafter.
Tax Deduction advantages: Tax is deducted at beneficial rates for those with a marginal tax rate greater than 30%. Once matured, the proceeds are tax-free in your hands.
Estate Planning Benefits: You can nominate a beneficiary or transfer ownership of the endowment. This avoids executor fees, saving up to 3.5% (excluding 15% VAT).
Insolvency Protection: After three years, the fund value of an endowment is protected from creditors. This protection extends for five years after termination if proceeds are payable to your spouse, children, or parents.
Benefits
Tax Efficiency: Endowments ease administrative burdens by having the life insurance company pay tax on your behalf. The tax rates on the respective investments within an endowment are a 30% income tax rate, a 20% dividend withholding tax, and a 12% net capital gain tax rate. This can be compared to tax on general unit trust investments, where interest is taxed at an individual’s marginal income tax rate, 20% dividend withholding tax, and 18% effective capital gain rate.
Disciplined Savings: Limited accessibility during the initial term ensures you stay committed to your financial goals over the medium to long term. Endowments do allow one withdrawal within the initial five-year investment term.
Flexibility at Maturity: Once your policy matures, you have unlimited access to funds. This enables options such as regular withdrawals to supplement retirement income, ad hoc withdrawals, or accessing a lump sum for major expenses. Proceeds from mature policies are tax-free.
Estate Planning Advantages: By nominating a beneficiary or transferring ownership to another individual, you avoid executor’s fees (up to 3.5%, excluding VAT), making endowments an attractive estate planning tool. Should you pass away before maturity, the proceeds will be paid out to your nominated beneficiaries, or they can be listed as beneficial owners of the policy and continue with the investment.
Insolvency Protection: Protects your assets from creditors after three years, adding a layer of financial security.
Obligations
Regular Premium Payments: A commitment to consistent contributions is essential to maintain the policy.
Early Withdrawals: Withdrawals within the first five years may not be more than the contributions accumulated at 5% per year compound interest. This is important to understand, as this does mean there is some flexibility regarding withdrawals, especially in an emergency. Understanding the impact of early termination or withdrawals is crucial, as these may incur penalties and affect your savings.
Related investments
Alternative Endowment Policies Some providers have designed endowment policies that provide a capital guarantee at the end of the five-year term that will ensure that the initial lump sum capital invested is protected till maturity. You will also receive a monthly income during the five-year term. These policies are great investment vehicles to supplement pre- or post-retirement income should you have capital to invest. Income is also taxed at a very low rate (at times only 34% of the income earned is taxable).
Sinking Funds are a type of investment issued by insurance companies to companies. They are similar to endowment policies in that they also have a five-year term and certain tax benefits. The tax rates on items within the company-owned sinking fund policy are 27% Income Tax Rate, 0% Dividend Withholding Tax, and 21.6% Net Capital Gain Tax Rate. There is no tax payable at the end of the investment term.
Common Questions about Endowments
To better understand how endowments work and how to use them effectively, let’s address some frequently asked questions.
What are the costs associated with an endowment?
Costs may include administration fees, investment management fees, and penalties for early withdrawals. These vary by provider and policy. It is very important to understand, challenge, and compare the fees, as high fees can undermine the performance of the investment.
Can I choose where my money is invested?
Many endowments offer a range of investment options, such as unit trusts or balanced portfolios, allowing you to align your investments with your risk tolerance and goals. Generally, using ETFs (passive funds) vs. actively managed funds within the endowment will reduce fees and increase returns over the term of the policy.
What happens if my investments underperform?
The returns on your endowment are subject to the performance of the underlying investments. As mentioned above, some policies may offer guarantees to protect your capital. Typically, however, policies with a capital guarantee have higher fees, as the capital guarantee will be a feature that is charged for.
Can I transfer ownership of an endowment?
Yes, you can transfer ownership of the policy to another person, such as a spouse or child, under certain conditions.
What happens if I stop paying premiums?
If premiums are not paid, the policy may lapse, reduce in value due to penalties, or be terminated, depending on the terms of the policy. Your fund value will remain in the investment policy but will have to stay invested till maturity at the end of the five-year term.
Do endowments impact my personal tax return?
No, since the insurance company pays the tax on your behalf, there is no need to declare the returns on your personal tax return.
We hope that you now have a better understanding of endowments and how you can use these investment products to suit your personal investment and financial needs!
While endowment policies can have very specific contractual fees and rules that need to be carefully considered, generally they are ideal investments for individuals with a tax rate higher than 30%. They are also great for those seeking disciplined, tax-efficient savings over a medium- to long-term horizon, especially if you’ve maximised contributions to tax-free savings accounts. They are particularly beneficial for planned future expenses, such as a child’s education, a dream vacation, or retirement planning.
In the next article, we will unbox Retirement Annuities (RAs) and how they have excellent tax benefits which help to super-size the growth of your investments. So, stay tuned!
Have any questions for us on this blog post? Please send them to us at info@zenmunni.co.za.
If you are struggling with knowing how to invest, or have too much debt, call us 087 183 5012 or WhatsApp us on 076 451 6944, or email us at info@zenmunni.co.za. We are FAIS and NCR registered, and we can partner with you to grow and build your wealth.
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