Endowments are an overlooked instrument among people seeking to maximise the tax efficiency of their investment portfolios, but they can be a useful tool under certain circumstances. They are particularly useful for people who have a higher marginal tax rate than 30%.
We believe that the only class of endowment that is really worth looking at is a new-age product that acts as a wrapper and offers the investor a flexible choice of underlying funds and instruments such as equities, property, bonds and cash. Let’s briefly consider some of the advantages and disadvantages of endowments:
Advantages
Under certain circumstances, endowments can be a useful estate planning tool. You can place the endowment outside of the estate to save as much as 3.5% plus VAT on executor’s fees, though the estate duty will still be payable. Plus, an endowment can be paid upon your death before the estate is finalised, giving you the peace of mind of knowing that your loved ones will have access to money if something happens to you.
For high-income earners, there are also tax benefits, especially once you have maxed out your tax free and retirement savings allowances and your tax exemption on interest. Endowment income is taxed at 30% and endowment capital gains at 12%, compared to the maximum 45% income tax rate and the 18% capital gains tax rate. The insurance company pays the tax on your behalf, so there are no tax reporting requirements on your side.
You can also structure endowments to offer protection against creditors for insolvency protection.
Disadvantages
One of the biggest downsides of endowments is that they often involve locking your funds down for a term of five years or more, with only partial access to your money. If you need to access the funds, you will in many cases need to take a loan against the endowment – often paying higher interest than the returns from the endowment – or pay a cancellation penalty. In addition, the endowment wrapper may add another level of costs to your portfolio.
Investors should also be aware that endowments could be subject to sweeping tax changes to the so-called ‘five funds approach’ that might remove the tax advantages of endowments overnight. Such a move might be attractive to a cash-strapped government since it would affect only wealthy investors and hence not be politically sensitive.
When endowments make sense
Endowments might be more tax-efficient for you than local unit trusts containing cash, bonds and property stocks if your marginal income tax rate is higher than 30%. They can also make sense where you are already using your maximum capital gains tax rebate. However, in our experience, most investors pay more capital gains tax than income tax when they are in retirement and are already paying a lower tax rate.
For offshore investments, we favour accumulation class or roll-up unit trusts or mutual funds, where no income tax is payable and capital gains tax is paid only when you exit the investment. This is a highly tax-efficient option. However, endowments can be of value as a wrapper for share portfolios where foreign dividend’s tax and inheritance tax are payable based on where the shares are listed, and capital gains tax is payable on portfolio switches.
That’s a topic I’ll examine in detail in my next article.
Here are the links to the other articles in our series on tax-efficient investing:
Part 3 – Tax-free Savings Accounts
Part 4 – Tax Impacts of Trusts
Part 5 – The upsides and downsides of endowments (current article)
