The Individual Savings Account (Isa) is approaching its twentieth birthday, and since its inception it has been hugely popular.
In the last tax year alone, 10.8m adult Isas were opened. But despite this popularity, have savers made the most of the opportunity?
When the Isa launched in 1999, it had an annual allowance of £7,000 for Stocks and Shares Isas, and just £3,000 for Cash Isas. Today, there is a far more generous annual limit of £20,000.
Isas have encouraged a generation to save for their future, secure in the knowledge that their returns will be shielded from the taxman.
These tax-efficient wrappers are particularly useful when it comes to gains you can make through a Stocks and Shares Isa, because you don’t pay any income tax on either dividends paid on your share holdings or on the interest paid on your bonds.
And when you sell the holdings or take money out, you don’t pay capital gains tax on any realised profits either.
It doesn’t end there. Isas save you ploughing through a mountain of paperwork – because of the baked-in tax benefits, you don’t have to include it in your annual tax return.
Whether it’s for retirement savings, a house deposit, or helping children in the future, Isas are a powerful vehicle to shelter returns from tax.
And if you want to maximise your savings, using an Isa to access the returns of financial markets is one of the best ways to help meet your goals.
You’ve got the power
Cash savings are useful, versatile, and dependable. Before considering other types of investments, it makes sense to build up a cash buffer of three to four months’ expenses to help deal with the unexpected.
But over the longer term, investments in riskier assets, such as shares, can significantly outpace the growth of cash savings, especially with savings rates at their current low levels.
A Stocks and Shares Isa can also help to counter the corrosive impact of inflation on savings over the long term. This is because asset classes that offer the potential for higher returns (as well as typically carrying more risk), are more effective at harnessing the power of compounding returns.
Imagine an investor who has used their maximum Stocks and Shares Isa allowance every year since the scheme’s inception in 1999, contributing a total of £203,440.
If they had invested in the FTSE All-Share Index, a benchmark of UK equities, their Isa would be worth around £360,000 after 20 years.
Compare this with the returns on cash: the same amount invested in a cash equivalent would have amounted to just £220,000 over the same time period.
And our hypothetical investor would have fared even better by going global and tapping into the significant growth that shares of the world’s biggest technology giants have enjoyed in recent years.
If they’d invested in global equities, represented by the FTSE All-World Index, 20 years’ worth of Isa allowances would have grown to more than £460,000.
This is more than double what the same amount invested in a cash equivalent would have delivered – and all with no tax to pay on dividends or capital gains.
Of course, many aspects of investing are outside your control.
It is nigh on impossible to predict the returns you can expect over a lifetime of investing, and the value of investments, and both the income from them may fall or rise. You might even get back less than you invested.
Accurately timing the market is also extremely difficult, even for professional investors.
But tax is a drag on investment performance which is – at least to a certain extent – within your control. By investing tax-efficiently – within an Isa – this hurdle is removed.
You can also control your costs. In most areas of life, the more you pay for something, the better the product you expect to get. Investing, however, is counter-intuitive – you get what you don’t pay for.
Read more: 14 shares for your ISA
Some Isa providers charge more than others, and the more you pay in fees, the less of your returns you get to keep for yourself.
For most ordinary investors, the best path to accumulating wealth is to harness the power of long-term compounding of returns.
And it works best by keeping costs – both investment fees and taxes – as low as possible.