The returns on Cash ISAs have been hugely disappointing for a number of years. Currently, obtaining an inflation-beating interest rate from a Cash ISA is incredibly challenging, while interest rates are expected to stay at low levels over the coming years.
Despite this, Cash ISAs are still popular among people who are looking to build a nest egg for the future to generate a passive income. A better means of doing so could be to follow these three steps and avoid Cash ISAs altogether.
Open a Stocks and Shares ISA
A Stocks and Shares ISA may sound much more complicated than a Cash ISA, but it is essentially just an account through which you buy and sell shares. In this regard, it is very similar to a bog-standard online share-dealing account, but there is usually an additional charge for administration. In many cases this amounts to little more than £1 per month.
The major benefit of using a Stocks and Shares ISA versus a regular share-dealing account is its tax efficiency. There will be no capital gains, income or dividend tax charged on any amounts invested in or withdrawn from a Stocks and Shares ISA. This means that building a retirement nest egg and then generating a passive income from it is much easier than it would otherwise be as you will not pay any tax.
Invest regularly in shares
Most people do not have a lump sum to invest in the stock market. If you do, then buying stocks in one go could be a good idea since history shows that their returns are significantly higher than other mainstream assets.
If you do not have a lump sum to invest, setting up a standing order from your current account that pays money on a regular basis to your Stocks and Shares ISA could be a good idea. Using this money to regularly buy a diverse range of shares could provide you with access to the high-single-digit annual returns that indexes such as the FTSE 100 have delivered over recent decades.
Through buying a diverse range of shares, and even starting off with a tracker fund that aims to mimic the returns of a specific index, you could generate far higher returns than those available via a Cash ISA.
Hold for the long term and reinvest
It is tempting to spend the dividends and capital returns you generate within your Stocks and Shares ISA. However, reinvesting them and holding on to your investments for the long term could increase your chances of generating a rising passive income in older age.
It allows compounding to have a positive impact on your portfolio. Over time, this could enable you to enjoy a financially-free retirement, and may further widen the difference in returns between shares and a Cash ISA.
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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.