Isa millionaires: A guide to building tax-free prosperity

There is a split between the chancers that struck it rich through a risky strategy and those investors that applied more reasoned judgements

THE end of another tax year looms, but it seems from figures released by HM Revenue and Customs for 2010/11 that as far as investment Isas are concerned, we’ve seen more talk than action. The data reveals that only 7 per cent of the UK adult population have a stocks and shares Isa and among those that do the average invested is £4,613 – less than half the amount that could currently be invested each year.

These are amazingly low take up figures. The value of an Isa’s benefit depends on each individual’s circumstances; while the case for investment Isas for basic rate taxpayers is not clear cut, in my opinion it is difficult to argue against the benefits for a higher rate tax payer. As the 40 per cent tax becomes payable on gross income of £42,475 (£41,450 from April 2013) for this year, it’s clear that for many people, it’s a missed opportunity.

The key to understanding the true potential of investment Isas is not to look upon them as a one-off annual tax savings account but to view them as a life-long fiscal planning tool. A number of our clients who have recognised this have already become Isa millionaires.

Although these people are extreme examples, they illustrate the long-term potential of these tax efficient vehicles. They have viewed Isas – and in most cases their predecessor the Personal Equity Plan (Pep) – as long term tax efficient shelters, built brick-by-brick, year-by-year. Although to achieve these value levels they have obviously made some great investment decisions, you can build up your own shelters more quickly than you may think. Even if you focus just on the Isa era which began in 1999 (the monies held in Peps were transferrable to Isas), a married couple could have made contributions to investment Isas alone of £202,560.

The Isa millionaire story is obviously not just about contributions. It’s about capital growth. We should not forget though that most Isa investors don’t become millionaires. Some will achieve more modest levels of growth and some will lose. Isas merely inflate growth, by reducing tax, where it is achieved. Those who have achieved the status or even lesser degrees of success tend to fall into two categories: the chancers and the investors.

Some Isa millionaires have followed a strategy of having lots of eggs in a few baskets. They have backed their judgment in one or two companies and for them it has paid off. This is a very high-risk strategy and there are examples of investors who have lost significant amounts of money by adopting such a focused plan.

There is no doubt that diversification reduces risk. I often refer to the 10-2 guideline which states: do not put more than 10 per cent of your portfolio into one company and don’t invest in more than two companies in one sector. This policy would have served you well over the years but the chancers have paid no heed to such a risk reducing strategy. An example of a chancers stock is Tullow Oil. As you will see from the chart (above) over the last five years investing in Tullow Oil would have quadrupled your contributions. Those who have followed this strategy clearly demonstrate that the age old relationship between risk and reward still applies as it always has and to date they have achieved greater rewards for taking bigger risks. It won’t always have such a happy ending.

Some have achieved Isa millionaire status by a far more measured approach. They have built their tax efficient shelter not just in the Isa era but in the previous Pep period which started over 25 years ago. They have taken a long-term view and in many cases appreciated the importance of both reinvested dividends and dividend growth to the overall performance of equity investment. SSE (previously Scottish and Southern Energy) is a great example of such a stock. Although over the last five years this stock has lost about 15 per cent in terms of its share price (above), if purchased in 1989 at 240p the present dividend of 6.1 per cent on its current value – at the time of writing £13.30 – would represent an annual return on the dividend alone of over 30 per cent based on the original investment back in 1989.

Past performance is not, of course, a reliable indicator of future performance. The figures speak for themselves. But there is one more point I would make for those people who have opted for the “no risk” alternative of cash Isas. Although there is extra risk in investing in stocks and shares Isas – you can lose money – one of the best methods of reducing the risk of the stock market is to feed money in over time. This reduces the chance of getting your short-term timing wrong and allows you to benefit from pound cost averaging if the markets move against you. This simply means you will buy more shares if prices fall and therefore reduce the average book value of shares purchased. Isas with their annual allowances force investors to adopt such an approach. Although it only reduces the risk and does not eradicate it, for some it may be enough to make them think again about this much underused tax efficient vehicle.

John Cotter is a vice president at Barclays Stockbrokers.