This article is part of the special series, Investing with ISAs.
A £1 million ISA sounds like the stuff of fantasy for most of us. But is this lofty achievement really so unattainable? The numbers may surprise you.
Consistent contributions from an early age, and the compounding effects of investment returns, can combine to produce results beyond what many of us would have thought possible
The key is not in scoring a lottery-style win on the shares of a junior mining company, but in patiently letting time or money—ideally, both—work in your favour. Consistent contributions from an early age, and the compounding effects of investment returns, can combine to produce results beyond what many of us would have thought possible.
Crunching some figures will illustrate the point:
In the first example, let’s say you begin contributing to an ISA at age 35 and with some stability in your career and income you are then able to contribute the maximum amount of £11,520 per year. (This is the maximum allowance for the 2013-2014 tax year for stocks and shares ISAs.) This maximum level will likely increase over time to keep pace with inflation, but for the sake of argument we’ll assume that contributions stay constant over time at £11,520 per year. If you diligently keep up those annual subscriptions, you will need to achieve an average return of 6.54% per year in order to end up with an ISA worth £1 million after 30 years.
If that level of annual contribution isn’t feasible, get time on your side by starting early, or advising your children to do so. If you started at age 18 and made contributions until your 70th birthday, you would need only to contribute £2,520 per year to build up a £1 million ISA, assuming you got the same average return of 6.54% per annum. Extending the time horizon of your contribution period can go a long way towards building your nest egg.
A Decent Rate of Return is Crucial
Similarly, the average rate of return you achieve over the life of your ISA will have a massive impact on its end value. In our first example, if your annual gain is 2% instead of 6.54% it wouldn’t take you 30 years to get to £1 million, it would take 50. Furthermore, in 30 years you would not even have reached half the amount as under the higher return scenario, despite having contributed just as much.
Getting decent portfolio returns in an ISA is a little more realistic than it might be for your broader portfolio because the ISA investments are able to accumulate without incurring tax on income, capital gains, or dividends.*
Here's a hypothetical example to illustrate the point: let's assume your marginal tax rate on investments— including income, capital gains and dividends—was 30% when you invested outside of an ISA. In this scenario, to get that same 6.54% return in a taxable account you would need to make a gross gain of 9.34% each year. Clearly, what would be a very tricky feat outside an ISA is much more manageable within.
Be Realistic in Your Expectations
Of course there will always be a wide range in the investment results from one investor to the next. ISAs were introduced in 1999, and there are already tales of ISA millionaires. To get to that level in just 13 years, even under the upcoming subscription limit of £11,520, requires the formidable task of earning an average rate of return of more than 28% per year. In fact any ISA millionaires that do exist today have done even better than that, since the subscription limit was just £7,000 for the first few years of the plan.
Even without being lucky enough to find investments that grow at 30% a year for more than a decade, our examples should illustrate that in the long run, with diligent savings and investments, building a sizeable portfolio is within reach. For our future selves, a bigger question may be: how far will my £1 million go, after the tug of inflation has taken its toll for so many years?
*Note, that ISAs are not completely tax immune. Dividends generated from equity, both inside and outside an ISA, will automatically have a 10% tax skimmed off the top by the government. If you're a higher rate taxpayer you would normally pay tax on dividend income at 32.5% or 42.5%, but inside an ISA you only have to pay 10%. This 10% tax only applies to equity dividends. It does not apply to income paid by corporate bonds or gilts within ISAs.
