What is an accumulation unit in finance?

An accumulation unit is an amount of money someone invests in a particular investment called an investment trust. When you invest in everyday things, like stocks, you hope the stocks will increase in value over time. And, while you’re waiting for the stocks to go up, the companies will often pay you a little bit of money regularly, called a dividend.

But investment trusts are different. They don’t pay dividends when you put money into an investment trust. Instead, they add any money the investments make to the total amount invested. So your original investment keeps growing by the amount it’s earning rather than paying it out to you. Each amount you invest is called an “accumulation unit.”

How accumulation units work

Let’s say you have $1000 and decide to invest it in an accumulation unit of an investment trust. The investment trust takes your $1000 and pools it with other investors’ money. They use all this money to buy various investments, like stocks, bonds, real estate, or anything else the trust focuses on.

Now, let’s imagine that after one year, the investments that the trust bought with your money have earned a 10% return. If this was a regular investment, they might pay out that 10% to you as a dividend. However, since this is an accumulation unit, the trust takes that 10% (which would be $100 in this case) and adds it to your original $1000 investment.

So now, your accumulation unit is worth $1100 instead of $1000. The following year, if the investments earn another 10%, that’s 10% of $1100 (which is $110) that gets added to your investment, so now your accumulation unit would be worth $1210.

This process continues for as long as you hold the accumulation unit. The earnings are reinvested and added to your original amount, so your investment grows over time.

Advantages of accumulation units

One significant advantage of accumulation units is that your investment can grow faster over time than when you receive dividends and take them out. This is because of compounding.

Compounding is when you earn returns not just on your original investment but also on your previous returns. In the example above, you earned 10% on your original $1000 and the $100 in earnings from the first year in the second year. This compounding effect can add up over time.

Another advantage is that it’s straightforward to reinvest your returns with accumulation units because the reinvestment happens automatically. If you were receiving dividends, you’d have to take that money and decide to reinvest it yourself, which takes more effort, and you might be tempted to spend the dividends instead.

Accumulation units can also be more tax-efficient in some cases. You often have to pay taxes on dividends as you receive them. But with accumulation units, you generally don’t pay taxes until you sell your units and take the money out. This means your investment can grow tax-deferred, making a big difference over long periods.

How to invest in accumulation units

If you’re interested in investing in accumulation units, the first step is to find an investment trust that offers them. There are many different investment trusts, and they can focus on stocks, bonds, real estate, or specific industries.

Once you’ve found an investment trust you’re interested in, you must open an account with them. This usually involves filling out some paperwork and providing identification. You’ll also need to decide how much money you want to invest.

Most investment trusts will have a minimum investment amount for their accumulation units. This can vary greatly depending on the trust, but it’s often around $1000 or $2000.

Once your account is set up and funded, you can instruct the trust to purchase accumulation units for you. The price of each unit will depend on the current value of the trust’s investments.

Risks of accumulation units

While accumulation units have several advantages, it’s essential to understand that they also come with risks, just like any investment.

The most significant risk is that the value of your accumulation units can fluctuate. Remember, the trust is using your money to buy investments, and all investments can lose value at times due to market downturns, economic recessions, or problems with individual companies or properties the trust has invested in.

If the value of the trust’s investments decreases, so will your accumulation units’ value. And since you’re not receiving dividends, you won’t have any income from your investment to offset those losses.

Another risk to consider is liquidity risk. Investment trusts are not as quickly traded as stocks. Suppose you need to sell your accumulation units. In that case, you might not be able to do so soon or at a reasonable price, especially if many other investors try to sell simultaneously.

There’s also the risk that the investment trust could perform poorly due to bad management decisions. The returns on your accumulation units depend on the trust’s managers’ skill in choosing suitable investments.

Accumulation units vs income units

Many investment trusts offer two types of units: accumulation units and income units. We’ve been focusing on accumulation units, but let’s take a moment to understand how they differ from income units.

The critical difference is in what happens to the returns earned by the trust’s investments. With accumulation units, as we’ve seen, those returns are automatically reinvested back into the trust. With income units, the returns are paid out to the investors as dividends.

You’ll receive regular dividend payments from the trust if you own income units. The frequency of these payments can vary, but they’re often paid quarterly or semi-annually.

The choice between accumulation units and income units depends on your financial goals. If your primary goal is long-term growth, and you don’t need regular income from your investments, accumulation units can be a good choice. The automatic reinvestment of returns can help your investment grow faster over time.

On the other hand, if you’re looking for investments to provide you with a regular income stream, income units might be more suitable. For example, this could be the case if you’re retired and looking to supplement your pension income.

It’s worth noting that the fees for accumulation units and income units can sometimes differ. In some cases, accumulation units might have slightly higher fees because more administrative work is involved in reinvesting the returns. However, this isn’t always the case, and the difference in fees is usually tiny.

Converting between accumulation and income units

Some investment trusts allow you to convert between accumulation units and income units. So, if your financial goals change over time, you might be able to switch from one type of unit to the other.

For example, let’s invest in accumulation units during your working years for long-term growth. As you approach retirement, you might decide that you’d prefer to start receiving a regular income from your investment. You could potentially convert your accumulation units to income units at this point.

The specific rules and procedures for converting units can vary between investment trusts. Certain restrictions or waiting periods might apply, and fees may be charged. It’s essential to check the specific policies of the trust you’re invested in.

Tax considerations for accumulation units

The tax treatment of accumulation units can be complex and vary depending on your country and personal tax situation. It’s always a good idea to consult a qualified tax professional.

That being said, here are some general tax considerations to keep in mind with accumulation units:

Tax deferral

One of the potential tax advantages of accumulation units is that they can allow for tax-deferred growth. This means you don’t pay taxes on the returns your investment earns until you sell your units and take the money out.

This differs from investments that pay out dividends, where you typically have to pay taxes on the dividends as you receive them, even if you reinvest them.

Tax deferral can be beneficial because it allows your investment to grow faster. The money that would have gone to taxes is instead reinvested and compounded over time.

Capital gains tax

When you sell your accumulation units, your profit will typically be subject to capital gains tax. The exact capital gains tax rate can depend on factors like how long you held the investment and your overall income level.

In some countries, capital gains are taxed lower than ordinary income, making accumulation units more tax-efficient than investments that pay taxable dividends.

Inheritance tax

If you pass away while holding accumulation units, the value of those units might be included in your estate for inheritance tax purposes. Again, the specific rules can vary greatly depending on your country and situation.

Some countries provide tax relief for specific investment holdings left as an inheritance, so it’s worth investigating what rules might apply to your accumulation units.

As with any investment, it’s crucial to consider potential tax implications when deciding whether accumulation units suit you. Always research and seek professional advice to understand how the tax rules apply in your case.

As a final point

Accumulation units can be a powerful tool for long-term investment growth. By automatically reinvesting returns, you can benefit from the power of compounding, potentially leading to higher growth over time compared to investments that pay out dividends.

They can also offer some tax advantages, such as the potential for tax-deferred growth and lower capital gains tax rates than ordinary income.

However, accumulation units also come with risks. The value of your units can fluctuate and potentially decrease, and you might face liquidity issues if you need to sell your units quickly.

As with any investment decision, you must consider your financial goals, risk tolerance, and tax situation when deciding whether accumulation units suit you. Diversification is also vital—accumulation units should typically be just one part of a balanced investment portfolio.

If you decide to invest in accumulation units, be sure to do thorough research on the specific investment trust you’re considering. Understand its investment strategy, track record, fees, and policies regarding unit conversions.

And remember, investing is a long-term game. The benefits of accumulation units are most powerful over extended periods, thanks to the magic of compounding. Have patience, stay disciplined, and always remember your ultimate financial goals.

With careful consideration and a well-thought-out strategy, accumulation units can be a valuable addition to your investment toolkit, helping you build wealth over the long term.