Question:
What are the tax implications of an endowment policy that matures this year?

Answer:
Understanding the tax treatment of different investment vehicles is critical when determining the right vehicle for you. A mere two percent gained or lost by using the incorrect vehicle could have devastating consequences to your final payout.

By categorising investments into three broad areas we will gain some understanding of how our investments (both current and future) are treated in the eyes of the taxman.

Firstly, let’s look at retirement funds (e.g. pensions, provident funds, retirement annuities and living annuities). Trevor Manuel announced in his budget speech a few years ago that all retirement funds will be free of any tax. This means that all the net rental property and interest will be free of any income tax and also no Capital Gains Tax (CGT) will be collected on the gains within the portfolio.

This is a massive benefit for those desperately trying to secure their retirement provision. One should be quick to note that once you retire, all income that accrues from your living annuity is taxable at your marginal rate of tax. The exception to this is the concessions made at retirement where any lump sum taken is taxed according to a tax table. Essentially what this means is that the first R300 000 may be taken free of tax with the following R300 000 taxed at 18 percent, the next R300 000 at 27 percent and any amount over this at 36 percent.

Endowments

Secondly, let’s consider endowments as per the original question. Endowments are governed by the Long-Term Insurance Act and are therefore taxed within the investment by what is known as the 'four-fund approach'. The four funds refer to separate 'pools' for individuals, companies, corporates and those that are untaxed (public benefit organisations, churches, etc.) Each one is taxed differently. Assuming we are looking at an individual’s investment, then the taxation applicable will be a flat 30 percent tax on all net rental income (if there is property in the portfolio) and interest (accrued from fixed instruments). This then means that all capital gains will attract CGT at a rate of 7.5 percent. This tax is paid within the fund and on behalf of the investor. The result is that the proceeds will be free of any tax purely because it has already been paid within the fund.

The only exception to this is second-hand policies (where you are not the original beneficial owner) where CGT will also be payable by the investor on deemed disposal and on top of CGT already paid within the fund.

Lastly, collective investment schemes (i.e. unit trusts): These investments are governed by the Collective Investment Schemes Act and all taxation is dealt with in the hands of the investor. Now before we discard this all together, one must look a little closer…

Although all income, interest and capital gains accrue directly to the investor there is some benefit to this. Firstly, if your tax rate is under 30 percent then it becomes a 'no-brainer' as you will undoubtedly be in a better tax position. What is more, SARS allows for certain exemptions when it comes to interest and capital gains. For the tax year 2009/2010, the first R21 000 (under 65s) or R30 000 (over 65s) earned in interest is exempt from income tax. Similarly, capital gains up to R17 500 per annum are also exempt, however, it must be noted that a deemed disposal (selling or switching of units) must have taken place to benefit from this. So, just in the example of interest, one could easily have up to R300 000 (assuming you’re under 65 and earning seven percent per annum) invested in interest bearing instruments without attracting any income tax. Take this one step further — if interest bearing investments constitute only 30 percent of your portfolio (think balanced fund), you could have R1-million invested without any income tax payable.

In conclusion, retirement funds will give you tax free growth both pre and post retirement with the eventual income being taxable at your marginal rate which could be markedly lower in retirement. Endowments will be taxed according to the four-fund approach within the fund and therefore no exemptions can be claimed and all proceeds will be post-tax and therefore free of any tax within your hands. And finally, all collective investments are taxed within your own hands with the benefit of certain exemptions being allowed.

Please remember that there are other considerations when selecting the right vehicle and one’s decision should not be based on tax alone. For this reason it is advisable that you seek the professional opinion of a Certified Financial Planner.

All the best.

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