FOOL'S EYE VIEW
What You Can Save With An ISA

By Maynard Paton (TMFMayn)
November 28, 2001

Carburton Street, London -- Individual Savings Accounts are great. They protect your investments from tax. If you invest with a long-term horizon, then the tax savings can be substantial.

To recap, a maximum of £7,000 per tax year can be sheltered in an ISA. Full details of the different types of ISA avialable can be found here. However, the most popular variant is the Maxi Stocks and Shares ISA. Here, an investor's £7,000 can be fully invested on the stock market via a fund or through individual shares. And with the stock market historically outperforming other forms of investment, the tax savings can be all the more significant.

Let's look at a simple example that gives an idea of the performance required to generate these savings.

Imagine investing £3,000 within an ISA every year for five years. Also imagine that your shares or fund produces 8% growth per annum. For simplicity, assume the growth is purely capital growth and no dividend income is received. What's more, assume none of the investments are sold at any time.

Here's how the ISA's would look fifteen years after the first one was opened.

        Amount      No. Years     Total        Gain
       Invested     Invested       (£)          (£)
         (£)                   

        3,000          11         6,995        3,995
        3,000          12         7,555        4,555
        3,000          13         8,159        5,159
        3,000          14         8,812        5,812
        3,000          15         9,517        6,517

Total  15,000                    41,036       26,036

You'd have recorded a tax-free gain of £26,036. Had you invested in the same shares or fund outside an ISA, and wanted to sell out completely after fifteen years, you'd be saddled with a taxable gain of nearly £5,000 (assuming the present Capital Gains Tax (CGT) allowance rises at 2.5% per annum and the current taper relief regime remains the same).

At the lower 20% rate of tax, your CGT bill would thus be a little under £1,000. It's certainly a saving, although it would be largely offset by ISA management charges levied over the years.

Miracle

Of course, with the miracle of compound returns, the tax savings increase as time goes on. Here's the situation after ten further years of 8% annual capital growth.

        Amount      No. Years     Total        Gain
       Invested     Invested       (£)          (£)
         (£)                   

        3,000          21        15,102       12,102
        3,000          22        16,310       13,310
        3,000          23        17,614       14,614
        3,000          24        19,024       16,024
        3,000          25        20,545       17,545

Total  15,000                    88,594       73,594

Using the earlier assumptions, the non-ISA investor would have a chargeable gain of over £30,000 after 25 years of investing. That equates to a £12,000 CGT bill for a higher rate taxpayer. Paying, say, £1,500 in ISA management charges over that period looks a much better proposition.

Furthermore, by jacking up the amounts invested at the start, the tax savings can become even greater.

        Amount      No. Years     Total        Gain
       Invested     Invested       (£)          (£) 
         (£)                   

        7,000          21        35,237       28,237
        7,000          22        38,056       31,056
        7,000          23        41,110       34,100
        7,000          24        44,388       37,388
        7,000          25        47,939       40,939

Total  35,000                   206,720      171,720

With £35,000 invested over the first five years, and 8% annual growth, the ISA investor would be sitting now on a tax-free gain of £171,720. But using the earlier assumptions, at the higher rate of tax, the non-ISA investor would be facing a tax bill of about £36,000.

And just to highlight the really big tax savings that can be made through ISAs, here are the figures should you be lucky enough to earn a 15% annual return on your investments.

        Amount      No. Years     Total        Gain
       Invested     Invested       (£)          (£) 
          (£)                   

        7,000          21       131,751      124,751
        7,000          22       151,513      144,513
        7,000          23       174,240      167,240
        7,000          24       200,376      193,376
        7,000          25       230,433      223,433

Total  35,000                   888,313      853,313

In this situation, the non-ISA investor would face a tax bill of around £200,000 should they want to dispose of their entire portfolio after 25 years. However, the ISA investor would have generated the £853,313 gain tax-free!

Reality

Of course, theory is one thing; reality is another! For instance, there's the question of non-ISA investors fully utilising their annual CGT allowances. Then there are the assumptions concerning levels of future CGT allowances and taper relief. Also, there's the issue of dividend income, which was ignored in the above examples. Finally, there's the subject of ISA management charges, which may vary in the years ahead. (This post by Foolish regular Gengulphus goes into more detail on these topics).

But the overall ISA message is clear. While nobody can foresee their exact investment returns, the longer your investing time horizon, the more likely you'll make a substantial CGT saving. ISAs are thus ideal vehicles to help boost your retirement pot. What's more, ISAs will protect you from any unfavourable changes in the CGT regime.

All that said, there are other advantages in using ISAs. Probably the biggest non-tax advantage is that you don't have to ever consider CGT. In addition, you don't have to mention your ISAs to the Inland Revenue. Anybody who has had to fiddle about with indexation, or spent many an hour contemplating how best to utilise their annual CGT allowance, will find ISAs save much time and effort, too!

More: Discover more about ISAs in The Motley Fool's ISA Centre