Over time, investing in a Stocks and Shares ISA instead of a general investment account can substantially enhance returns by shielding gains from punishing taxes.
To give you a flavour, the estimated tax relief cost to the exchequer from all ISA products (including Cash ISAs) came to £3.8bn in 2020-2021. The amount’s likely to be much higher today too, as ISA uptake has since increased.
Boosted by these tax savings, here’s how someone with £500 to invest each month could unlock a substantial passive income for retirement.
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Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Choose wisely
Across the ISA range, investors have a variety of ways to make their money work for them. They can buy a large range of shares, funds and trusts from the UK and overseas in a Stocks and Shares ISA. Or they can simply hold cash on account with the — you guessed it — Cash ISA.
Having said that, the long-term returns that can be expected from each of these products can differ greatly. Let’s say someone decides to keep things simple and low-risk by investing £500 each month in their Cash ISA.
With a realistic average interest rate of 4% over 30 years, they’d turn that into £347,025, and then an annual passive income of £13,811. The latter figure assumes that our saver drew down 4% of their nest egg to live on each year.
But there’s a huge problem here. This £13.8k figure is far below the £31,300 that the Pensions and Lifetime Savings Association (PLSA) says people need for a moderately comfortable retirement. Even the addition of the State Pension might not get them close to this target.
This is where investing in shares as well can be make a difference.
A £28,215 passive income
Based on past performance, an average annual return of 8% is pretty realistic, in my view, although not guaranteed. But of course, the amount someone invests versus how much they save in cash — and as a consequence their final return — will depend on investment goals and tolerance of risk.
Let’s say our individual invests £450 a month in a Stocks and Shares ISA and deposits the remaining £50 in a 4%-yielding Cash ISA. If they can hit that 8% annual return on their riskier investments, they’d have a retirement fund of £705,364.
Breaking it down, they’d have made £670,662 from their share investments and £34,702 from their cash holdings. This in turn could provide an annual passive income of £28,215, based on a 4% drawdown rate.
A top fund
Investing £450 out of a possible £500 is an aggressive approach. But an individual could reduce the risk by putting their money in an exchange-traded fund (ETF) like the Vanguard FTSE 250 ETF (LSE:VMIG).
As the name implies, this vehicle spreads investors’ capital over 250 mid-cap UK companies. These businesses span a variety of different sectors, and just over half of cumulative earnings come from foreign markets, giving the fund excellent diversification.
Though its performance could be impacted by broader volatility on stock markets, I believe it’s still an attractive option for long-term investors to consider.
The FTSE 250 index has delivered an average annual return of 8.7% over the past 20 years. If this continues, our ISA investor parking £450 in this fund each month stands an excellent chance of retiring in comfort.
