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Retirement saving: this simple trick could help you reach £1m faster

I was recently asked about the difference between investing though buying accumulation units and income units in equity funds. Which ‘share class’ should you buy for the best returns, and why?

The short answer is very simple. As a general rule, always buy accumulation — ‘Acc’ — units unless you want to receive a cash income from your fund holdings.

Buying income — Inc’ — units when you don’t need the income could cause you to lose a lot of money. Even if you reinvest the income back into the fund, you could still lose out.

Let me explain.

Acc vs Inc: what’s the difference?

Most funds offer investors the choice of income and accumulation units. Both will be invested in the same assets. What’s different is the way that income such as dividends is handled.

Income units: If you buy income units in a fund, income earned from the fund’s investments will be paid to you in cash each year. The value of the income units will move in line with the price of the fund’s assets.

Accumulation units: If you buy accumulation units, all income from the fund’s assets will be automatically reinvested into the fund. This carries no charges and it means that the value of the units is boosted by income each year, in addition to any capital gains (or losses).

The great advantage of this is that your investment returns will benefit from compounding. This means earning income on the previous years’ income.

The ‘trick’ of compounding

Einstein is said to have described compound interest as the eighth wonder of the world. It’s a powerful way to make your money work for you and build wealth.

I’ve calculated some example figures showing the difference in returns an investor might expect from income and accumulation units.

I’ve based these numbers on a £5,000 investment in a fund that delivers a 4% income and 4% growth each year.

Year

Value of income units + income received

Accumulation units

Extra earned by Acc units

1

£5,400.00

£5,400.00

£0

5

£7,166.53

£7,346.64

£180.11

10

£9.802.44

£10,794.63

£992.18

20

£16.911.23

£23,304.79

£6,393.55

As you can see, accumulating your income makes a very big difference over longer periods.

Accumulation vs reinvesting

The only problem with accumulation units is that you can never receive any income. That’s why some investors choose to buy income units and then reinvest the cash into the same fund, buying more income units.

In theory, this should provide a similar result to accumulation units. In reality, you’re likely to fall short. There are several possible reasons for this.

Costs: Buying more units may incur a charge. You will also have to pay the ‘offer’ price to buy the units, which is higher than the ‘bid’ price at which you can sell them. Your purchase will also be rounded down to the nearest whole unit.

Timing: With accumulation units, income never leaves the fund and is seamlessly reinvested. With income units, the income leaves the fund for a period of time before you can reinvest it. You may not be entitled to income earned by the fund during this period.

What next?

These comments apply to most equity funds, including FTSE tracker funds and popular choices like Woodford Equity and Fundsmith.

If you are in any doubt about the most suitable unit for your needs, I’d recommend taking professional advice. Choosing the wrong option could be costly.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.