The tax-free ISA is the most versatile saving and investment plan. Here are five ways to use it to your advantage.
The ISA or Individual Savings Account is permanently tax-exempt. So once you have put money into an ISA, you need never pay a penny of tax again, either on the profits you make or the income you get as interest or dividends.
Over a short period, not incurring tax doesn’t make a lot of difference to the net return you get, but over a period of years the effect mounts up. Assume you get 6.5% before tax; then at the normal 20% tax rate, you get 5.2% after tax.
The sums saved quickly add up
Tuck away £3,000 for five years and if you earned 5.2% each year you would end up with £3,890 whereas if you earned 6.5% a year the final sum would be £4,150. After ten years the gap would have widened with final sums of £5,040 (5.2%) and £5,740 (at 6.5%).
The figures get more dramatic when you look at regular saving. On a saving of £100 per month for ten years, an annual return of 5.2% means you accumulate £15,700 but at 6.5% the final sum would be £16,840. Over 20 years the end result at 6.5% is £49,000, over £7,000 more than if your return was 5.2%.
So the ISA is great for accumulating capital. But the tax exemption also means it’s a good place to draw income from. Say you needed to draw a net income of £3,000 a year from your savings.
No limit to the amount you can hold in an ISA
If you had to pay tax on that income, you’d actually need a pre-tax income of £3,750. Assuming you could draw a 5% income, you’d need capital of £75,000. But if you didn’t pay any tax, then £60,000 would be enough to generate the same net income of £3,000.
There’s no upper limit to the amount you can have in ISAs. If you put in the maximum of (currently) £7,200 a year, it would take you 35½ years to become a millionaire, again assuming an annual return of 6.5%.
Stock market investments often produce higher returns, and if you got 9% a year you’d be a millionaire in under 30 years.
Five top ways to use your ISA
*1: Save up for a home
If you need to accumulate cash towards the deposit for a house, put as much as you can into ISAs and you’ll move in quicker. Assuming two of you set up ISAs and put in the maximum £3,600 into a cash ISA each year, in four years you’ll have saved £28,000 which with interest will have grown to nearly £33,000. If you want to lock in a definite return, use a fixed rate ISA since there are currently plenty paying over 6.5%.
*2: Pay off your mortgage.
Instead of having a traditional repayment mortgage, have an interest-only mortgage and contribute to a monthly savings plan in an ISA to build up capital. You can use that capital to pay off the loan, or part of it, whenever you want to - but you don’t have to. So the ISA gives you a lot more flexibility than a repayment mortgage, and if you do this over a 25-year term on the basis I explain in this special feature, you are almost certain to be left with a big profit after paying off your loan.
In fact, on a £100,000 mortgage, your profit could be as much as £60,000.
*3: Fees, fees, fees
Over the first 21 years of their lives, children gobble up cash. At the least, you’re likely to have to support them through university, but there could be education fees before that too.
So start a regular savings plan with an ISA and build up capital you can use to help pay the fees. There are no restrictions on withdrawals, so you can draw out as much as you like - from capital or as income – without incurring any tax.
*4: Retirement income
Most people will need to supplement their pension income with additional income from savings. The ideal place to draw retirement income from is an ISA, because the income will be tax-free. So use an ISA to save regularly over the years up to retirement and then draw a tax-free income.
*5: Convert your capital
If you inherit capital, you’ll pay tax on the income and gains it generates. To avoid this, transfer the maximum £7,200 each year into an ISA and end up with a tax-free investment.
For the short-term, use the cash ISA. But for long-term savings, use stock market ISAs where returns have usually been much higher than the interest you get from deposits. To make the most of your ISA, set up a self-select plan.
You’ll get discounts on the funds you buy and access to research as well as virtually free online switching between funds.
It is easy to get the timing wrong with lump sum investments. It’s impossible to get it wrong with regular saving if you stick at it for ten years. Somewhere in there you’re bound to have a period of low prices that enables you to accumulate lots of cheap investments. Then, the only issue will be whether and when you cash in some of your gains.
The £600 per month ISA savings plan
| Type of fund | Name of fund | Amount per month |
| UK: aims for high and rising income | Martin Currie UK Equity Income | £200 |
| Worldwide: focus on small growth companies | Rathbone Global Opportunities | £200 |
| Natural resources | JP Morgan Natural Resources | £100 |
| Worldwide commercial property | SLI Select Property | £100 |
| TOTAL | | £600 |
Why these funds?
These funds are all run by managers with a proven record of success. They not only invest in different areas but have different styles of investing. That means that in most market conditions at least one of them should thrive.
I recommend that all investors have a holding in a UK Equity Income fund because over the long term these have proved excellent investments that have often produced higher returns than more risky growth-oriented funds.
At present, Martin Currie’s UK Equity Income fund has an income yield from dividends of 4.1% net of standard rate tax. It’s very likely that this income will grow by between 5% and 10% a year over a 5-10 year period. If that happens the capital value of the fund is also almost certain to rise.
Good track record
Scott McKenzie is not as well known as some other UK Equity Income fund managers but has an excellent personal track record with his previous firm Britannia Fund Managers, and in the two years he has been at Martin Currie he has significantly improved this fund’s performance.
Globalisation has made the world a smaller place. That is good news for investment managers of funds like Rathbone Global Opportunities, who can find well-managed fast-growing businesses all over the world.
James Thomson is a globe-trotting manager who focuses on the quality of the business and doesn’t worry much about the geography. Because he invests mainly in smaller companies, his Rathbone Global Opportunities fund will be more volatile than a typical international fund, but is likely to generate higher returns over a period of three-five years.
A long bull market in resources
Energy and resource prices are rising, and according to many analysts could go on rising for up to 20 years. There will be a rollercoaster effect - the price of a fund like JP Morgan Natural Resources will probably rise and fall more steeply than other investments - but this is actually good news for regular savers, who benefit from ‘cost averaging’.
Ian Henderson has run the JP Morgan Natural Resources fund for 15 years with great results. He holds a wide portfolio of shares in mainly medium sized and smaller companies, where he often discovers hidden value. The fund holds energy, precious metal and base metal mining and other natural resource shares.
Global property
Standard Life Investments’ Select Property is one of a handful of funds investing globally in commercial property. Manager Andrew Jackson draws on a huge international team of analysts and managers and this has enabled him to buy into property in Japan, Poland and other markets on attractive terms.
This is a volatile fund because many of the holdings are property businesses with stock market listings, but over a five-year term I believe it will do very well for its investors.
Important risk warning - please read
The value of your investment and the income from it can go down as well as up and you may not get back a significant proportion of your investment. Past performance is not an indication of future performance. If you are in any doubt as to the suitability of an investment, you should seek independent financial advice.
