Endowment: The Investment Basics

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A pure Endowment is an insurance policy that is used as an investment vehicle by investing in underlying funds (Unit Trusts). The entire premium paid towards the policy is allocated towards the investment after costs have been deducted.

There is no life cover on Endowment policies; however a beneficiary can be added to which the proceeds of the policy will be paid in the event of the investors’ death. Endowments can also be ceded as security.

The proceeds from Endowment policies are paid out to the investor tax free at the end of the term, this means that the investor can then receive the full tax free lump sum or withdraw portions of this lump sum annually as a form of tax free income. Even though the proceeds of an Endowment policy are tax free there is still tax payable during the duration of the investment term.

Tax payable

Endowments are taxed in terms of the Four Fund Approach as set out in Section 29A of the Income Tax Act of 1962. The Four Fund Approach refers to the separate pools at which individuals, companies, corporate entities and non-taxable entities, are taxed.

There are two types of tax applicable to Endowments, namely:

Income Tax – The Income Tax applicable to Endowments is withheld at source, which means that the insurance or investment company administrating the investment will pay tax on the investors’ behalf. Individuals and trusts with natural persons as beneficiaries will be taxed at a fixed rate of 30%, whereas companies and trusts with corporate entities as beneficiaries will be taxed at a fixed rate of 28%.

Capital Gains Tax – The Capital Gains Tax payable is also done so at source (paid by the Insurance or Investment company on behalf of the investors). Individuals and Trusts with natural persons as beneficiaries will have an effective Capital Gains Tax rate of 10%, whereas Companies and Trusts with corporate entities as beneficiaries will have an effective Capital Gains Tax rate of 18.67%.

Endowments tend to be more beneficial investment solutions for investors with higher tax rates or for estate planning purposes. One of the only other reasons for making use of Endowments is in the case of investors that lack discipline when it comes to saving as the restriction period applicable might put them off ending their Endowment policy before its maturity so as to avoid the steep penalties often involved with such cancellations.

The restriction period

The restriction period refers to the minimum contract period for which an Endowment must be undertaken. According to current legislation the minimum restriction period is five years. During this five year restriction period the investment or insurance company may not:

  • Fully surrender the policy
  • Loan the full investment value to the investor

The 120% rule

The 120% rule is important to know as it affects the restriction period. In the event of the investor increasing their monthly or annual contributions by more than 20% than the previous year a new five year restriction period will be applied.


For example:

In 2005, an investor takes out a R1000 monthly Endowment policy, with no fixed annual contribution increases. This Endowment policy will have a restriction period valid until 2010.

In 2008, the same investor increases their premium to R2000 per month. Since this is more than a 20% increase in monthly contributions, a new five-year restriction period will be applied, which means that the full proceeds from this Endowment are only available in 2013.

In the event of the investor wanting to make an annual or monthly contribution increase of more than 20% such as in the example they should rather take out a separate Endowment policy so as to retain access to the proceeds of the Endowment set at the first restriction period (2010).

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Check out these other great articles by Raul:

Unit Trusts: The Investment basics
Unit Trusts: Fees and Taxation

Sources:

Blake, L. (2012).Does It Ever Make Sense To Own An Endowment Policy? http://www.insurancefundi.co.za/endowment. Last accessed 22nd July 2012

Botha, M. et al., (2012).The South African Financial Planning Handbook 2012. Durban: LexisNexis. 725.

Netto-Jonker, D. (2009).Unit Trust vs. Endowment Benefits. http://www.financialplanningsouthafrica.com/unit-trust-benefit-vs-endowment.html Last accessed 22nd July 2012

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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.