How an Isa could earn you a million

The route to tax-free prosperity is simple

AS THE end of another tax year approaches, there is still time for investors to shelter up to £11,280 from taxation. But with most experts predicting cash Isas will undershoot inflation, it is surprising that, although close to half of the UK’s adult population holds an Isa, very few use the tax wrapper for investment purposes.

And some investors have been hugely successful. The exact number of Isa millionaires (those with more than £1m sheltered in an Isa tax wrapper) is unknown, but the number of investors who have been playing their cards right since the introduction of the Isa’s predecessor (the personal equity plan) in 1987 is growing. Brewin Dolphin, for example, has 18 Isa millionaires, with the largest portfolio valued at £6.3m. So how can you make the most of your Isa in 2013, not only as a shelter from tax but also a vehicle for growth?

EARLY BIRDS
An Isa should be the cornerstone of any investment strategy, and the sooner you can start making contributions, the better. Fidelity Worldwide Investment has found that, assuming the full Isa allowance is used from April 2013, and given an annual growth rate of 5 per cent, if a person started investing in an Isa at 18, by age 50 they would hold £1,162,691.

RAINY DAY
But in the current environment, it is hard for investors to get real returns on cash Isas, given that inflation is running at 2.7 per cent. All investors should have some rainy day funds, however, so it is logical to hold this in a cash Isa, where they will at least be sheltered from tax. And there are a few cash Isas offering decent interest rates. MoneySupermarket notes that BM Savings’s three-year fixed-rate Isa pays 2.8 per cent annual interest. And Which? lists the Cheshire Building Society’s 3 per cent Isa as one of the best instant-access cash Isas available.

LONG-TERM PLANNING
To make the best use of an allowance, therefore, investors need to hold a stocks and shares Isa. These give you the flexibility to build a portfolio that meets your investment objectives, and “there are tools and research available to help you manage your portfolio,” says Catherine Penney of Barclays Stockbrokers. And they also have double the total tax free allowance -- £11,280 compared to £5,640 for cash.

Bonds are commonly viewed as the next stop on the risk curve from cash, and can be purchased through an equities Isa. But with valuations high, they may not represent the best long-term value. And although the headline yield of corporate bonds can be attractive, there’s still a risk of capital loss.

The key is to view an Isa as a long-term fiscal planning tool, so the younger people are, and the more risk they’re willing to take, “the more of their portfolio should be directed towards equities,” says Jason Whitcombe of Evolve Financial Planners. The best method of gaining exposure might be through buying a fund. If keeping costs to a minimum is a high priority, a tracker rather than an actively-managed fund is better, as the latter will incur a fund charge – usually around 1 per cent. And if you’re planning for retirement, that 1 per cent can eat into returns over time.

If you decide to directly purchase equities, avoid using past performance as an indicator of future performance. Top performing assets one year can continue to do well the next, or “they can drop to the bottom of the list,” warns Tom Stevenson of Fidelity. Similarly, investors shouldn’t put their total allowance into equities unless they’re comfortable with a higher risk to their capital.

MILLIONAIRE’S STRATEGY
But the trend among Isa millionaires has tended to be towards putting all their eggs in a few baskets. Some of the Isa millionaires at Barclays Stockbrokers, for example, have backed their judgment in one or two companies. “Their strategies have paid off, but they were risky,” says Penney.

Peter Day of Killik – which boasts 16 Isa millionaires – says those clients are all actively-managing their Isas, and ensuring that they take full advantage of their allowances every year, even if the outlook doesn’t look especially positive. Regardless of whether you manage to earn a million, compounding over the years is the best strategy. Whitcombe advises making contributions on a monthly rather than annual basis; it means you’re far more likely to stick to target.

Even if making it to Isa millionaire status is beyond your reach (and these people are extreme examples), there are ways to increase risk if you have the appetite – through investing in emerging market funds, for example. You may not become a millionaire, but you will be among the few making the most of this widely underutilised tax efficient vehicle.

TOP SELLING IMA SECTORS INTO AN ISA (GROSS) JAN 2013

UK All Companies
UK Equity Income
Mixed Investment 20-60%
Shares
Sterling Strategic Bond
UK Money Market

TOP SELLING FUNDS INTO AN ISA (GROSS) JAN 2013

Isa Cash Park
Invesco Perpetual High Income
Invesco Perpetual Distribution
First State Global Emerging Markets Leaders
M&G Global Dividend
Invesco Perpetual Monthly Income Plus