Make the most of an ISA, and you could become ISA rich
Traditional planning has tipped its hat to pensions being the main financial instrument for most people. And whilst this still rings true, the relative restrictions of pensions, and the market expansion of accessible investments, generates options for those looking for a more flexible investment option. What is arguably at the forefront is the Individual Savings Account (ISA).
An ISA (cash, or stock and shares here, but there are other kinds) is a great tool for many financial plans. Firstly, for the flexibility it adds by offering a way to invest or save that doesn’t lock money away until age 57 (i.e., a pension) and by offering tax-free withdrawals. Secondly an ISA allows an individual to grow wealth tax-efficiently as there is no tax levied on interest or growth, and there is a broad range of investment options.
An ISA is a useful component for a financial plan, but how does one become ISA-rich? Well firstly by taking advantage of compounding of interest or growth, and secondly by regular saving and self-discipline… the latter is particularly important for those younger and in the ‘accumulation’ stage of their life.
Compounding allows an individual’s money to grow over a period from both the initial investments, and accumulated earnings from these investments. This allows a pot to grow exponentially with there being effectively growth on growth, as opposed to linear growth of interest on the initial investment only.
I am young and am thinking about growing my assets – Is an ISA only practical for those wealthy enough to invest hefty sums?
The short answer is no. Presently, £20,000 is the maximum amount an individual can put into an ISA per tax year (the ISA allowance). Those who are younger and/or have lower earnings may not have the ability to use this fully, but if this is the case, your youth means you have more time on your side to benefit from compounding.
An individual at this stage should determine what is affordable to invest and think about a regular contribution. This means, alongside your pension, and perhaps your first home; up to 100% of your assets can be growing tax-free. Therefore, an ISA can help you over the medium and long term, alongside any pension provision you may be building, but remain accessible should you need it.
I am approaching retirement and thinking about accessing my savings, I have an ISA but I haven’t fully contributed every year – is it too late to benefit from an ISA?
Also, no. An ISA remains a useful tool for an individual as they enter retirement as the tax-free withdrawals mean you can tax-efficiently provide yourself with an income stream, or a sum for a holiday, property purchase, or gift.
An ISA could top up any pension income you may be receiving via the income produced by the dividends (referred to as natural income), or by a pre-arranged income stream. The point is all these withdrawals are tax-free, enabling you to potentially be a nil-rate or basic rate taxpayer in retirement. The ISA need not be drawn on at all, depending on your other retirement provision.
The ISA pot could be left to grow with the aim to meet any costs of care in later life. Many individuals default is to use their home to pay for care costs, and whilst this is possible, growing an ISA (even starting one at retirement age) will give you flexibility. You can pay for care in your own home and avoid the hassle of selling in your later years. It also means you need not make large withdrawals from any pensions you have (therefore potentially generating unsavoury tax charges).
How much could I be accumulating in an ISA?
The following outlines how much could have been accumulated if you have contributed the full amount to a cash ISA or a stocks and shares ISA since they have been in existence. In reality, there are not many individuals who have done this, but crunching these numbers shows the potential benefits of saving or investing into an ISA for the future.
First the cash ISA
If you had fully used your allowance in a cash ISA each year since inception (April 1999) until April 2020 you will have saved £181,520. If you had earned interest only the equivalent of base rate of interest (which has been much lower than the best rates available), then you would be sitting on approximately £195,678.
Turning to the stocks and shares ISA
If you had fully used your allowance each year since April 1999 until April 2020 you will have saved £242,560. Using the global stock market (MSCI World index) and its annual returns over this period, you would instead be sitting on approximately £583,216
The difference in the amount saved and the final value for the stocks and shares ISA in particular shows the benefits of compounding and contributing regularly. And in fact, there are even cases of ISA millionaires. So, what about for those on lower incomes, or who cannot afford to make the full contributions?
Investments of £3,000 per year or £250 per month will also reflect the benefits. For a total saving/investment of £66,000 over the period, the final value of £77,945 for the cash ISA, and £186,305 for the stocks and shares ISA. Remember, this growth is tax-free, and tax-free to access. In a normal investment account, you may be liable to capital gains tax (CGT) on the profit, and in a pension, you will be liable to income tax. And finally, none of this considers the merits of a coherent investment strategy.
The ISA Millionaire theory uses the very same logic as the above: regular contributions tied in with the power of compounding. There are many studies which look at how much you should be putting into an ISA, to reach age 65 and have a million saved. These studies make relatively simplistic assumptions on salary, ISA legislation, and growth rates, but ultimately, they show that it is possible, theoretically…
Adding just a dash of reality to the theory invites the questioning of these assumptions, such as how can I be sure that my salary will increase in a linear fashion? And what about life events such as children, or perhaps redundancy? Whatever age you are, the affordability of ISA contributions at any given time will differ depending on a whole host of things.
Speaking to a financial adviser, the planning we do establishes affordability, and acknowledges and works with the individual nature of your situation.
What’s more, you may only be a ‘millionaire’ nominally. If you are investing over an extended period, you will have to address inflation. This could mean establishing and maintaining a risk-appropriate investment strategy.
Should you have savings, ISAs or other investments that you would like to be working harder for you or managed with a view to better achieving this goal, then this is where you should consult professional financial advice. You can get in touch with us and Arrange a free consultation today.
Please note: Tax planning is not regulated by the Financial Conduct Authority. Investments can go up as well as down. The figures in this article are for representation purposes only and do not constitute as individual advice. If you wish to know more then please speak to your TPO contact.