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Increased income tax rates

The recent budget proposed that personal income tax rates increase by 1%. This was done from the second bracket (those earning in excess of R181 900 per year) upwards, but considering adjustments to rebates and tax brackets there will only be tax relief for tax payers earning below R450 000 per year. The highest tax bracket for individuals has now increased to 41%. This tax rate now also applies to trusts (other than special trusts), which previously paid 40%.

When does an endowment make sense?

There are a number of factors to consider when choosing between a pure discretionary savings plan (DSP) or an endowment. This includes availability of interest and capital gains allowances as well as required access to capital within the first five years.

A key consideration in how to allocate between the two products is the clients’ tax rate. Income tax legislation requires policyholders of an endowment to be classified as an individual, company or untaxed policyholder and income and capital gains tax varies accordingly.

An endowment is available to individuals as well as trusts with individuals as beneficiaries with tax as follows: Tax on income at 30% and effective tax on capital gains at 10%.

Individuals in a DSP are now taxed at marginal rates up to 41% resulting in an effective tax rate on capital gains of 13.7%. For such high income earners the endowment can offer significant tax saving. Within the two products there is no differentiation for dividend tax, which is withheld at 15% either way.

How much can you save on tax in an endowment?

Consider an individual that has no interest and capital gains allowance available and invests R5m for 10 years. Assume a balanced fund-type investment with 11% return per annum and no trading of the portfolio over the period.

After five years, allowing redemptions for payment of income tax annually, such an investment would have grown to R8.16m in a DSP. An equivalent investment in an endowment would have grown to R8.23m, but saved about R145 000 over the period. This consists of:

  • income tax saving (30% versus 41% marginal rate assumed)
  • capital gains tax
  • saving (taking 100% of the capital gain into account)
  • additional return earned as a result of higher base to compound from

Over the full 10 year period assets in the DSP would be at R13.32m, but the investor would have missed out on a total saving of R426 000 relative to the endowment.

Do the math

Trusts or individuals with significant discretionary savings and high marginal tax rates should consider an endowment. There are restrictions that may not make it a suitable option, but multiple benefits and the significant potential tax saving are not to be ignored.

Benefits of an endowment

  • Greater tax efficiency for higher income earners (above 30% tax rate) who have exhausted their interest exemptions.
  • Beneficiary nomination can lead to potential savings on executor’s fees (up to 3.99% of fund value). Where a beneficiary has been nominated, payment of the death benefit does not depend on the winding up of the estate and beneficiaries will receive the proceeds relatively quickly.
  • Tax administration is taken care of on your behalf (the insurance company calculates, deducts and pays the tax to SARS).
  • Insolvency protection – the entire value of the endowment will be protected against creditors after three years. This protection will continue until five years after the termination of the policy.
  • Investors are not restricted to maximum levels of equities and offshore investments, as in the case of retirement savings products.
  • Investors can also use an endowment to draw income upon retirement – provided the five-year restricted period has passed. This may be done on an ad-hoc basis, and you are not forced to draw income at specific intervals.
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