Compounding opportunities

Compounding opportunities

The humble Individual Savings Account, or ISA, may be home to more than £600 billion of personal savings in the UK, but it has been overshadowed of late. Major reforms have transformed pensions, making them much less restrictive, and personal tax-free allowances have been introduced for dividend and savings income.

For long-term investors, though, ISAs have lost none of their shine. The wrappers are not only flexible – they can hold cash savings as well as investments in stocks and shares, and more recently peer-to-peer loans – but all income and capital gains, however great, are free from personal taxation.

As always, please remember that the value of the fund’s assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. ISA tax rules may change in the future and their tax advantages will depend on your individual circumstances.

The power of compounding

The simple reason why investing in an ISA can be so effective is compounding. The sooner money is invested, the longer it can work to deliver returns.

Where long-term investors can afford to invest at the start of the tax year, rather than topping up their ISA at the last minute, they not only gain a year’s performance, but these extra gains will be reinvested in the market until they need the money. Over time, the effect of compounding can be significant.

If you invest in a fund that grows 3% a year after charges, for instance, a £10,000 investment made on day one of the tax year will gain £300 after 12 months. Assuming 3% net returns over a 25-year investment period, this ‘extra’ £300 will compound to £628.

The more you invest, the greater the potential impact of early investing. Likewise, the longer you are investing for, the larger the compounding effect. To emphasise this point, let’s take two investors: one invests £10,000 in their stocks and shares ISA at the start of each tax year for 10 years, while the other invests just before the deadline every year. Assuming annual returns after charges of 3%, the early-bird’s pot will be worth £3,439 more than the last minute investor’s at the end of the decade. After 20 years on these same assumptions, the gain would be £8,061.

Therefore, investing early in the tax year to benefit from compounding is most pertinent not only for those saving for retirement, but also for parents investing for their children’s future through dedicated Junior ISAs, or JISAs.

These products, which can only be tapped when a child reaches the age of 18, carry the same tax-exempt status, but only £9,000 can be saved into each JISA each year.

Investing the maximum amount into an ISA each April will of course not be possible for most of us. The potential upsides of compounding can, however, be enjoyed by investing in a stocks and shares ISA as early as possible in the tax year, or through a plan of regular monthly investment.

Important information

When you’re deciding how to invest, it’s important to remember that ISA and Junior ISA tax rules may change in the future and their tax advantages depend on your individual circumstances. The value and income from the fund’s assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.

The views expressed in this document should not be taken as a recommendation, advice or forecast. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser.