Endowments and unit trusts are both popular after-tax investment vehicles. Both allow you to invest with an investment manager guided by an investment mandate. This means that you understand and agree to the level of risk you are willing to undertake to achieve a set goal within a specific time-frame.
A common misconception about both is that people think that they are a ‘type’ of investment. Therefore the term “vehicles”.
- An endowment is an investment ‘vehicle’ that holds an underlying investment fund.
- A unit trust is an investment ‘vehicle’ that holds an underlying asset portfolio.
The tax treatment on investment income and capital gains within a unit trust and an endowment can be very different, so it is important to understand the basics of each vehicle.
A decision to use an endowment should primarily be made for tax and estate planning purposes, and not for investment reasons. Another misconception that should be jettisoned is that endowments are “tax free”. In the case of an endowment, tax on investment income is withheld and dealt with, within the investment itself at a rate of 30% for a natural person. Interest earned within an endowment will be taxed at the 30% rate from the first Rand. The proceeds which are paid to the investor will not attract further tax once in their hands when reaching maturity.
However, one should be aware that tax has in fact been collected on the income since the establishment of the endowment. Capital Gains Tax (CGT) will also be withheld and paid to SARS by the administrator once the underlying investment within the endowment has matured.
In the case of a unit trust investor, there are three types of tax. As unit trusts have a small level of cash on hand at all times, income tax has to be paid on the interest earned by this cash. This interest is taxed in the investors hands and will depend on the individual’s marginal rate, up to a current maximum of 45%, on income earned.
Please note that there is an exemption on interest earned. Currently the first R23 800 (for under 65’s) of interest earned by an individual is exempt of income tax. The second type of tax applicable is capital gains tax (CGT). This is applied to the increase in the capital amount caused by the increase in the unit price of the investment and only takes place at re-purchase. Once again there is an exemption. The first R40 000 of capital growth, taking all assets sold in the tax period into consideration, is exempt from CGT. At the maximum marginal tax rate, capital gains tax will be levied at an effective rate of 18% on the gain made. The last type of tax is the dividend withholding tax. As the underlying investment in unit trusts are made up of equities, shareholders are rewarded by dividends. All dividends are taxed at 20% at source before distribution to shareholders. There is no tax on dividends in a shareholder’s name.
When an Endowment Make Sense?
An endowment may make sense for an individual who:
- Has a marginal tax rate of greater than 30%.
- Has utilised their annual tax-free interest income exemption (currently R23 800 for taxpayers under the age of 65 and R34 500 for taxpayers over the age of 65).
- Are looking for long-term investment vehicles, as they have a minimum maturity period of five years.
Access: it is possible to access some funds from an endowment before the five-year period in the event of an emergency, but there are some restrictions. It is possible to withdraw contributions plus 5% compound interest, but there are limited withdrawal opportunities. With regards to Unit Trust there is unlimited access to your funds.
Beneficiaries: it is possible to appoint a beneficiary on an endowment policy. In the event of the owner’s death, proceeds could therefore be paid relatively quickly to a beneficiary, and no executor fees would be paid. This is not the case with a Unit Trust investment.
Finally, you can cede an endowments policy as collateral for a loan and it is also possible to have joint owners on an endowment policy. Again, this option is not available with unit trusts.
As individuals we are all different, so our advice is to engage with one of our Financial Planners to explore what option would better suit you and your investment needs.