ISAs, or Individual Savings Accounts, are a valuable shield against tax for UK investors. You can currently put away up to £20,000 a year in ISAs, and any income or investment gains are free from income tax or capital gains tax – no matter how much money you make.
ISAs are available either as Cash, which is like having a tax-free bank or building society account, or Stocks & Shares where your money can be invested in a variety of assets in search of higher returns – albeit you could face losses as well as gains, especially in the short term.
Over time you can build up a substantial amount of money in ISAs and shelter it from tax. ISAs have now been around for over 20 years, and although they started off with a smaller annual allowance of £7,000 there are hundreds of ‘ISA millionaires’ who have built up seven-figure pots.
You don’t have to be a high roller to be part of this elite club, though. With a bit of research or professional advice when needed, anyone can take the necessary steps. Here are the ways in which investors have been able to maximise the value of their ISA wealth.
1. Use the stock market to your advantage
You will likely take far longer to reach millionaire status ISA if you leave your money in cash. Interest rates are generally well below the rate of inflation – the rate at which the cost of living rises – which is why many ISA holders turn to the stock market in search of better returns.
Some people are naturally risk-averse and find it difficult to take risk with their money. However, broadly speaking, the longer you can remain invested the greater tolerance of risk you are able to have and the higher exposure to more volatile areas is appropriate. The acceptance of a higher risk strategy is necessary to generate higher returns – but it does come at the expense of greater short-term swings in the value of your capital.
If you manage 5% annual investment growth you would hit the million-pound mark in 25 years with £20,000 invested each year. However, with a higher return of 7%, it would only take 21 years. Achieving a 2% return would stretch the necessary time to 34 years, which illustrates why long-term investors avoid holding too much cash. Low returns are a severe impediment to meeting retirement or other goals.
Going forward stock market returns could be lower than they have been historically, especially if economic growth and rates of inflation are lower. Yet the likelihood is that over the longer term the stock market represents an excellent way to generate an inflation-beating return on your money, and the recent market sell-off potentially opens up an opportunity for those that can look to the longer term.
2. Maximise contributions as best you can
The size of any ISA portfolio is a function of two things: how much is put in and the return generated. With many demands on our money, it may not be realistic for many people to use their full ISA allowance each year, but the more you save and the earlier you do so the better.
Putting aside a small amount each month can snowball into a sizable sum if you get the ingredients right. The important thing is getting started, and the earlier you do the more time your chosen investments have to grow.
Take two investors, both investing for retirement in 40 years' time. One starts investing £100 per month right away, the other does nothing for 20 years, but then invests £300 per month. The investments chosen both grow by 5% per year after charges. At retirement, the first investor will have spent £48,000 on their monthly contributions and the second investor £72,000. Yet despite having spent much less, the first investor's retirement pot would be worth £152,602 compared to the second investor's £123,310. By starting early, you give yourself the best chance of harnessing the long-term growth of stock markets.
3. Time and dedication
It will take a long time to become an ISA millionaire – unless you are exceptionally lucky or insightful and pinpoint very lucrative individual shares that rocket in value. Yet having a considerable amount invested in a single share means your success rests on the fortunes of a single company, so it means a very high level of risk.
Most people will rightly decide against such a strategy, though for those prepared to dedicate the time to thoroughly researching companies it can sometimes be fruitful. What tends to unite successful private investors is the enjoyment of the challenge of navigating a profitable path through markets and taking a keen interest in researching investments. This tends to take a lot of time and dedication. Fortunately, for those more ‘hands off’ or time-constrained, there are convenient ways to spread the risk and still generate decent returns from your ISA.
Many sensible investors use funds, which allow you to spread your money among lots of different shares at the same time, spreading the risk. Picking winning funds is not straightforward, however, but tends to be easier and less hands-on than researching individual company shares. Some of the fund sectors that have delivered for investors over the past decade include technology, biotech and smaller companies. Using investment trusts can also help boost returns. These often outperform fund equivalents because they can use gearing – or borrowing to invest. They can be riskier, though.
Find out more on different types of funds and their characteristics here.
4. Be patient and disciplined
Today’s ISA millionaires have seen many booms and busts but being too reactionary and trading in and out of the stock market over the short term can be unwise – even if political or economic reasons seem compelling. Not only are outcomes unpredictable, but so are their effects on financial markets.
It’s usually best to stick out tough times, stay invested and keep adding to your investments. As a patient investor with a long-term horizon time is on your side. Leaving money untouched and reinvesting returns is crucial to allow the magic of compound interest – earning interest on your interest – to take effect. There’s more on how compounding works here.
Very few people can time markets, and even fewer consistently. Clearly, there are severe corrections in the market from time to time that result in the loss of capital, and it is best to try and time your new investments to coincide with dips in the market, but this is easier said than done. In the long run, committing to riding out the peaks and troughs tends to provide a better result. Where you do take profits, keep your money in the ISA rather than withdrawing it to preserve that part of the ISA allowance you have built up.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.