What is ISA?
It is a collection of saving vehicles available to every U.K. resident aged 16 and over. Each person can park up to £20,000 per year into it and all income and capital appreciation are tax-free.
Different types of ISA
- Cash ISA
- Stocks and Shares ISA
- Innovative finance ISA
- Lifetime ISA (LISA)
- Help to Buy ISA (H2B)
- Junior ISA
I found a really helpful article that articulates the purpose and usage of these different types, which saves me time from explanation.
- The rate of return on Cash ISA is extremely low (2.3% is the highest rate available on the market so far).
- Innovative Finance ISA is too risky and “creative” for me.
- I use my SIPP for LISA functions.
- I already own my house to don’t need H2B.
- WB40 Junior isn’t yet born so I’m not eligible for Junior ISA.
3 reasons why you should save into an ISA
Here are the 3 reasons why it’s a great wealth building tool:
1. One of the surest ways to become a millionaire
There are many ways to become a millionaire and each with varying levels of difficulties and uncertainty. However saving in ISA is one of the surest way to become one as it is a mathematical certainty:
If you are a single person and contribute the full allowance every year (£20,000):
- Assuming an average annual compound growth rate of 5% (this is actually on the lower end as S&P 500 index returned just over 7% real term over the past 90 years)
- It would take 24 years for your portfolio to reach the £1 million mark.
If you are a couple then that time will be slashed to 17 years.
- Break down £20,000 into 12 increments (£1,667 for a single person or £3,334 for a couple).
- Set up a direct debit from your account to your brokerage account.
- Set up auto-invest into several index funds in the US, UK and Europe.
- Then forget about it.
- 17 or 24 years later, you will wake up and your net asset value of your portfolio should cross the £1,000,000 mark.
Don’t believe me? Read this real life story (and it’s on a previous allowance where the limit was almost half of the current one).
2. Income tax exemption
If you invest in an index stock market fund then your money will be spread across tens to hundreds of high quality blue chip companies, which more likely than not will generate a dividend (a portion of profit distributed to shareholders, mainly because these companies generate more profit than they can sensibly spend).
Dividends are treated as income, thus subject to income tax under normal circumstances. This can range between 20-45% in the U.K. Trust me, it feels horrible to have 40% of the dividend taken away by the taxman simply because you’ve been diligent in your research and frugal in your lifestyle.
Except for ISA!
Every single penny of dividend generate from your ISA portfolio is entirely free of income tax, so you can keep all of them and reinvest to achieve greater portfolio growth.
As you can see, you can already double your money by Year 35 at 2% whereas you’ve barely made more than 50% by the end of Year 40 at 1.2%!
3. Capital gains tax exemption
- It reduces your net return by 18% or 38% respectively.
- It can trigger tax-motivated trades (e.g. selling a stock at a loss to obtain CGT relief to minimise gains made earlier in the year).
Fear not if you have an ISA as it is entirely exempt from CGT.
- A $3,000 investment in Amazon.com in 1997 when it first went public would be worth more than $2,700,000 in its current share price (the link priced AMZN at $715 per share whereas today it’s taking at $1,400).
- You ISA allowance back in 1997 (it was called Personal Equity Plan at the time) was £9,000, well within the $3,000 investment requirement.
- This would net you a 900x return on your investment, entirely free of any form of taxation.
- If you invested outside of the ISA wrapper, then your post-tax proceed would be around $1,670,000 (at 38% capital gains rate), which lowers your ROI to 556x, which is still pretty handsome to be honest!