Investment Showdown: Endowment Policy vs Unit Trust

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When it comes to after-tax savings, two commonly used financial products are an endowment policy and unit trusts.

These products however have different tax treatments and benefit structures which should be understood beforehand to ensure correct use.

Just to recap these products can be defined as follows:

An endowment policy isn’t a pure investment vehicle, but rather a life policy that invests in underlying funds.

Unit trusts are pure investment vehicles, in which investors pool their funds together. 

Taxation on Your Endowment Policy and Unit Trusts

In terms of taxation, the investment income earned and capital gains made within unit trusts and endowments are treated differently.

Dividends earned however, are treated in the same way for both (Dividend Withholding Tax: What it is and How it Affects You).

Endowment Policy

There is a common misconception that endowments are tax free, largely due to the fact that they are incorrectly marketed.

An endowment policy is in fact taxed at a fixed rate of 30% during the course of the investment term.

It’s only after the endowment policy matures (reaches its end date) that the proceeds stop attracting tax in the hands of the owner.

This fixed tax rate of 30% is paid during the duration of the investment and any applicable Capital Gains Tax is paid at maturity.

These taxes are withheld by the investment administrator and aren’t paid directly by the investor. 

Unit Trusts 

When investing directly in unit trusts, investors are taxed at their marginal rate, which could vary up to a maximum of 40%.

Capital Gains Tax can also be levied if applicable, but in this case would be paid directly by the investor.

By investing directly in unit trusts, investors are able to utilise the annual interest exemption of R23 800 for individuals under the age of 65 and R33 000 for individuals 65 years and older, as well make use of the annual Capital Gains exemption of R30 000. These exemptions are not available for Endowments.

Important Differences Between Endowments and Unit Trusts

Endowments

Unit Trusts

Taxed at a fixed rate of 30% Taxed at the investor’s marginal rate, up to 40%
Interest exemption does not apply Interest exemption can be utilised
Capital Gains exemption does not apply Capital Gains exemption can be utilised
Minimum five year investment term Flexible and accessible
Can be ceded as security Cannot be ceded as security
Can appoint beneficiaries Cannot appoint beneficiaries
Restricted access to funds before the end of the investment term Unlimited access to funds
Tax efficient for individuals with a higher marginal tax rate than 30% who have already fully utilised their interest exemption Tax efficient for individuals with a marginal tax rate below 30%

When Should you Use an Endowment Policy?

Endowments aren’t all bad though. The following scenarios provide ideal situations in which to use endowments:

Individuals in higher tax brackets

Endowments make sense for individuals who are taxed at higher marginal rates than 30%. By making use of Endowments they will be reducing the tax payable on their investment.

It is however, important to remember the interest exemption of R23 800 for individuals under the age of 65 and R33 000 for those 65 years and older as this can be utilised first before making use of endowments for higher income earners.

Appointment of beneficiaries

Endowments allow the appointment of beneficiaries.

This means that proceeds could be paid quicker to beneficiaries in the event of death and would avoid executors’ fees due to the beneficiary nomination.

Collateral

Endowment policies can be ceded as security when collateral is required.

For more information regarding Endowments and Unit Trusts view the following:

Share your experience with endowment policies or any other investment vehicle in the comments below.

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As with most financial products endowments also have their time and place when used correctly. Be sure to consider the differences between these two products before deciding which will better suit your investment needs.

For all your financial planning and consulting requirements email Raul Jorge.

References:

Blake, L. (2012).Does It Ever Make Sense To Own An Endowment Policy? http://www.insurancefundi.co.za/endowment. Last accessed 1st July 2013.
Botha, M. et al., (2012).The South African Financial Planning Handbook 2012. Durban: LexisNexis. 725.
Debbie Netto-Jonker. (2009). Unit Trust Benefit vs Endowment?.Available: http://www.financialplanningsouthafrica.com/unit-trust-benefit-vs-endowment/. Last accessed 1st July 2013.
Mike Ronald. (2010). Understanding unit trust fees. Last accessed 1st July 2013.
Oldert et al. (2010). Profile’s Unit Trusts & Collective Investments. 2nd ed. Johannesburg: Profile Media. 89-93.
Rob Formby. (2010). Capital gains tax and how it affects unit trust investors. http://www.moneywebtax.co.za/moneywebtax/view/moneywebtax/en/page260?oid=48127&sn=Detail. Last accessed 1st July 2013.

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About Author

Raul Jorge is a CFP® professional at PSG. He specialises in estate, investment, retirement and risk planning. Prior to joining PSG, Raul completed his BSc (Honours) in Business Administration through the University of Wales and more recently completed his Postgraduate Diploma in Financial Planning through the University of Stellenbosch.