Saving for a £1m Isa: How the sums have changed
British savers have grown used to getting an annual increase in the amount they can tuck away in a tax-efficient Isa. But the increase this year is far bigger than usual. In the new tax year, which starts on 6 April, the allowance will increase from £15,240 to £20,000.
This changes the sums for those in a position to use the maximum allowance each year.
If you made full use of the new £20,000 allowance each year and your investments enjoyed the same returns of recent decades, your Isa pot could reach £1m in 23 years, four years quicker than with the old allowance.
Past performance does not offer a guide to future returns, but these calculations offer food for thought.
The chart below shows how using the additional £4,760 ramps up the size of your investment considerably quicker.
To make the calculation, we applied an annual return of 8.7%, because this has been the “total return” for the FTSE All Share index since 1983. Inflation of 2% was included, which is the Bank of England’s target rate.
Total return includes both the movement in share prices and income paid in dividends, which is reinvested. The reason equity investments grow faster than you might expect is because of the power of compounding. This is the effect of earning “interest on interest”. More is explained in this article: How the stockmarket returned 80% without moving.
What if I invested smaller amounts?
Investing the full Isa allowance each year will be out of reach for many. But regardless of how much you invest, there’s one important message from the data – the earlier you start saving, the better.
We’ve drawn up different scenarios for savers of different ages, using the same real returns data as above. Again, these returns may not be repeated.
– Did Isa savers return to cash at the wrong time?
The chart below shows what your pot would be worth if you invested £250 a month into the FTSE All Share, reinvesting dividends. It’s clear to see that time plays a huge part.
By starting at 25 the investor uses time to their advantage growing their investment to £571,346, again assuming the effect of 2% annual inflation. Over 40 years of working and saving, the individual has invested only £120,000. The difference in the numbers powerfully demonstrates the effects of compounding.
In comparison an individual starting at 55 receives the same return, but given the significantly shorter investment horizon the money doesn’t have time to “work” and is worth £42,110 from an investment of £36,000.
If an individual wanted to have £571,346 by age 65 but only started saving at 55, then staggering monthly payments of £4,609 would be required.
Isa vs non-Isa: another new calculation
It is also worth underlining the benefits of putting investments into an Isa, particularly after the UK government announced plans to cut the dividend allowance from £5,000 to £2,000 from next April. This is the amount anyone can earn in dividends before they need to start paying tax on them. Anyone holding investments worth more than £50,000 outside of an Isa is likely to face a higher tax bill as a result of the change.
The big appeal with Isas is that you don’t need to worry about a range of taxes.
For cash Isas, the savings interest is tax free. For stocks and shares Isas, investors don’t have to declare dividends or capital gains to the taxman.
Those who invest in the stock market without using Isas will see returns reduced, as the table below shows. The effects are shown for a range of portfolios for a higher rate taxpayer (someone earning above £43,000) investing £5,000, £10,000 or £20,000 annually for 10 years.
For simplicity we assume that dividends are taken as cash over the period. The portfolios highlighted are invested through a stocks and shares Isa. Again, we’ve used the FTSE All-Share past performance, which may not be repeated, to calculate investment returns.
Portfolio 1 and 2 both invest the full £20,000 allowance. As the first portfolio is invested through an Isa, a substantial £24,556 is saved in tax over ten years. For Portfolio 2, the effects of tax greatly reduce returns.
There are two reasons for this. Firstly, any dividend income above £2,000 is taxed at a rate of 32.5%. Secondly, when the shares are sold at the end of ten years, the non-Isa investments face a capital gains tax bill. The Isa is exempt from these deductions.
As we are allowed to hold one stocks and shares Isa each, a husband and wife could save £49,112 in tax bills over ten years if they were using their full allowance. The longer the holding period, the higher the potential tax benefits would be.
James Rainbow, Co-Head of UK Intermediary Business at Schroders, said: “When Isas were launched in 1999 with a £7,000 limit, it was unclear whether they would be accepted.
“Eighteen years on, their success has beaten all expectations. Last year alone (2015/16 tax year), nearly 13 million people subscribed to an Isa.
“The appeal is understandable, given the impressive returns stock market investing has offered. Nothing is ever guaranteed with the stock market but our calculations show how quickly your money could grow and why it makes sense to protect those gains from the taxman.
“Tax policies can change very rapidly. The cut in the tax-free dividend allowance from £5,000 to £2,000 has been made only a year after it was introduced. The basic tax efficiency of Isas, however, has remained a constant. It makes sense to use your allowance every year.”
Where do I start?
There’s a common misconception that you have to be wealthy to invest in the stock market. The majority of stocks and share Isas can be opened with regular investments of £25. Those looking to save for more than five years should look at opening a stocks and shares Isa, whilst those with a shorter time horizon might consider a cash Isa.
Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested
Important Information: The views and opinions contained herein are those of Ben Arnold, Investment Writer and James Rainbow, Co-Head of UK Intermediary Business may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. FTSE: FTSE International Limited (“FTSE”) © FTSE 2017. “FTSE®” is a trade mark of London Stock Exchange Plc and The Financial Times Limited and is used by FTSE International Limited under licence. All rights in the FTSE indices and / or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and / or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.