The case for endowments
Investors are often sceptical of endowments, but high-income earners could benefit from the lower tax rates levied on these products.
until very recently, the one job I would have avoided at all cost was that of a crane operator. If you had to measure my fear of heights on a scale of 1 to 5, it would probably rate closer to 45. In all honesty, though, if the government offered me the job of minister of finance today, you would have a tough time keeping up with me as I rush up the ladder to get to work.
In addition to the normal day-to-day dangers of losing his job, our current minister of finance, Pravin Gordhan, recently had the unpleasant task of informing us, as taxpayers, that the South African Revenue Service (Sars) reported a shortfall of R30.4bn for the 2016/17 financial year – the largest shortfall since 2009/10.
This resulted in two major shocks: an increase in dividends tax by a third from 15% to 20%, and an income tax rate of 45% for individuals earning in excess of R1.5m a year. By the time this article is published, countless economists and tax experts would have placed the new Budget under a microscope and most readers would have already decided whether it is good, bad or ugly.
This week, however, I would like to explore a possible solution available to an individual earning more than R1.5m a year and who is currently considering making an investment.
In the 2015/16 Budget, capital gains tax captured the spotlight after inclusion rates for individuals were increased to 40% and to 80% for legal entities. In my column Capital gains tax: Change your mindset dated 17 March 2016, I pointed out just how beneficial an endowment can be for a trust that only has natural persons as dependents/ beneficiaries. (An endowment is an insurance product that is designed to pay out a lump sum after a specific term.)
The problem, however, was that it didn’t necessarily offer the same benefits for individuals. Although this may not be the only reason why investors would invest via an endowment, the tax advantages attached to it certainly remain one of the biggest factors to consider it as an investment option.
What this means is that a person earning R240 000 a year at an average income tax rate of 14% won’t really enjoy the full benefits of 30% income tax and 12% capital gains tax on endowment offers. (See table below.)
The big question now is whether the higher-income groups, which will be largely affected by Gordhan’s recent announcements, won’t be able to benefit more from a tax perspective by investing via endowments.
Let’s suggest that a person who earns R2.4m a year would like to invest R2.5m either directly or via an endowment. For the purpose of this illustration, let’s use a 6.5% pre-taxed money-market rate, a 12% growth rate on their investments and in both cases, profits will only be realised after 10 years with a balanced capital distribution of 75% to growth assets and the remaining 25% allocated to money market.
By taking the new tax legislation into consideration, while everything else remains unchanged, this person’s investment should be worth R6 044 939 after taxes in 10 years’ time if invested directly in their personal capacity. Had they invested their capital via an endowment at an average endowment cost of 0.42% a year, the same investment would have a net worth of R6 135 946. If tax rates remain unchanged, you can add 1.5% in value to your investment by simply using the right investment vehicle, which in this case is an endowment.
The trust still reaps the most benefits from this type of investment. With the maximum tax rates increased from 41% to 45%, it also means that trusts’ capital gains tax rates have been increased from an already high level of 32.8% to 36%, and their income tax rates to 45%.
By using the same example as above, the same R2.5m investment would have had a net worth of only R5 290 051 after 10 years if invested directly. At current tax rates, a trust that did not apply the look-through principle (with only natural persons as dependents/beneficiaries), that invested via an endowment, however, according to the five-fund approach, would have paid only 12% capital gains tax and only 30% income tax. Not only would that have meant a massive R846 000 more in rand terms, but also an incredible 16% more in terms of performance.
If you, like many investors out there, still believe that endowments are worthless investment products that only add extra costs to your investments, think again. Not only as a trustee, but as an individual investor as well.