The brutality of tax on your investments | Impact, examples and strategies

ISA season is upon us so Peter McGahan takes a look at the benefits of the tax-free investment product and how you could be missing out!
tax-free ISA

The basic, but very important benefit is that of tax-free growth on your money. How important is that? Two reasons: You don’t have to manage the money in and out of where it’s invested to take care of annual tax allowances. This can cause advice charges, admin costs and dealing charges which are unnecessary; The money in an ISA simply grows free of tax, which of course rolls up in a compound manner.

Let’s look at the impact of that. If held outside an ISA, you may pay tax on your investments. The amount of tax you pay is different, depending on which vehicle you use, so we will use a 20 per cent tax rate below.

Investing for the future

We can’t guess what the future returns will be on a stock market, and this calculation is in no way doing that, but if I look at the returns from the S&P 500 over the last century, they average around 10 per cent. Over the last five years, it was 7.51 per cent, over 20 years, it’s 7.64 per cent, and over the last 30 years, its 7.52 per cent. (We have chosen 30 years to emphasise the point we are making and acknowledge ISAs were only introduced in April 1999).

So, let’s take a £20,000 maximum contribution into an ISA and see how that would have compounded to if it was growing tax free and what the difference would be if it wasn’t tax free.

After 30 years, if the average annual growth was 7.52 per cent, the £20,000 grows to £176,042.  If you decided to maximise the £20,000 contribution annually, the total return comes to £2,250,768. Now, this isn’t choosing the best fund you could have been invested into, nor does it allow for choosing an absolute howler of a fund, many of which exist. It doesn’t allow for charges either, so the numbers above could be more, or they could be less but it’s simply a direct comparison of the cost of tax on your investment.

The effect of 20% tax rate on savings

Now let’s look at what happens if we apply a tax rate of just 20 per cent to the assets as they grow.  The first calculation comes to £115,391, a far cry from the tax free £176,042. The gap of over £60,000 could nearly pay the extra annual heating costs in a home for the benefit of all those energy companies, bless ‘em!

If tax was paid in the second example of maximising the annual allowance of £20,000, the total return plummets to £1,700,380, a difference of over half a million pounds, or, £550,388 to be exact.

Today, there are over 1,800 ISA account holders who have ISA values growing free of tax where the value is greater than £1million. In fact, the average is £1.23million.

There are 60 ISA holders with values in excess of £3million, and those 60 have an average market value of £6,199,000. Lord Lee of Trafford is believed to be one of the top value accounts in the UK, particularly as he openly stated his ISA was valued at over £4.5million in 2015. There must be some pretty smart decisions in there to gain that sort of growth.

The UK has around 2.7million stocks and shares ISA holders enjoying the tax free roll up mentioned above. If you aren’t one of them, you should be, if you can be.

If one of the 1,800 ISA millionaires above, decided to take an income from the ISA at just 3 per cent, that is a tax-free income of £37,000.

To use an analogy, consider that a 20 per cent tax efficiency is the equivalent of working until Thursday and clocking off for a glass of wine, knowing you will be taking Friday off, and be paid for it. You don’t have to drink wine of course; you can just make your own call on that!

You can find out more about ISA value and popularity at ONS.

Discipline is key to successful investing

The key to maximising on the returns of course is to be disciplined around how you invest and looking to maximise the investment allowance each year.

This can be achieved by annual contributions, or just setting up a monthly contribution which eases that one off payment each year. More on that next week, and the benefits of monthly contributions which take advantage of market downturns.

If you have an ISA query, or for a complimentary 30-minute exploratory meeting regarding your investments, please ring 01872 222422 or email [email protected].

For more content about ISA and other savings accounts see Peter McGahan’s column on our Finance channel.

Tags: , , , Last modified: March 21, 2023

Written by 2:08 pm News & Views, Savings & Investments