Yes, You Absolutely Should Open An ISA

by The U.K. Income Investor

A poster on the UKInvesting subreddit recently asked about the merits of opening an ISA versus a traditional broker account. My honest view is that it’s one of the best things an individual can do in terms of their savings. Actually, let me expand that to include exploiting all tax-deferred and tax-exempt vehicles on the table.

To tackle the poster’s question head-on, the ISA itself is probably one of the greatest gifts that Parliament has ever bestowed on ordinary people. I mean that sincerely. A lot of people don’t even need a traditional broker account because the ISA rules are so generous.

ISA Benefits

To back that claim up let’s just run through the nuts and bolts of what they actually are. Firstly, the current contribution limits. Assuming you generate enough disposable income, you can stash £20,000 this year across the various types of ISA that exist. There are no income eligibility rules whatsoever, meaning you can earn £250,000 per year and still put the full £20,000 in.

Income and realised capital gains that occur within are obviously shielded from taxation, and that applies to withdrawals too. Also, since these are not strictly retirement accounts, there are no age qualifications or restrictions. You won’t be penalised if you make a withdrawal at, say, the age of 45. Not only that, but you don’t even need to report any of the activity to HMRC. Oh, spouses and civil partners can also inherit them from a deceased partner without losing tax-free status.

Long-Term Impact

If I ended the article now you’d leave with a good impression of how powerful ISAs are. Actually it gets even better. I mean you might think that a tax-exempt savings vehicle like that would have onerous restrictions on what you can invest in, right?

Nope, they are actually very open. Equities, bonds and cash are all on the table, as are the myriad of different types of funds that might invest in them: ETFs, OEICs, investment trusts and so on. Nor are you limited to UK-listed equities (a large proportion of foreign funds and ETFs won’t qualify, though). If you want to buy and hold foreign equities then you are perfectly entitled to, assuming the underlying shares are listed on a recognised stock exchange (the list is pretty comprehensive).

Want to buy a low-fee equity index tracker fund that charges a few basis points per year? No problem. You can put £1,666.67 per month into that for the rest of your life assuming the current contribution limits remain in place. Based on historical rates you might expect to compound away at a double-digit clip.

Now imagine trying that strategy out in a regular broker account. For one, you would probably have to pay tax on the dividends, thereby introducing a significant headwind to your overall rate of compounding (particularly for higher-rate or additional-rate taxpayers).

Consider the historical total returns of the S&P 500 as a rough guide to what that might look like. It has compounded away at an average rate of just over 10% per annum over the past three decades. Or put another way, if you invested $10,000 at this point in 1990 you would now be sitting on around $191,000 on a pre-fee, pre-tax basis.

(I’ve used US dollars and the S&P 500 to illustrate my point for simplicity. Needless to say he same principle applies to a domestic equity index tracker using pounds sterling, even if the returns are different).

Now knock just one percentage point off that compound average return rate. Your gut instinct might tell you that it won’t make all that much difference to the end result. I mean 9% per annum versus 10% per annum: aren’t we splitting hairs? Nope, in actual fact it is enough to cut the total return down by 30%. Now imagine applying that concept on up to £20,000 worth of fresh capital every single year. The numbers get quite big, even over the space of a decade or two.

Junior ISAs

I don’t see nearly as much commentary on Junior ISAs as they deserve. The name obviously tells you what you need to know: ISAs for kids. Contribution limits are a lot lower, I’m guessing because the effect of giving someone an 18-year head start in terms of tax-free compounding is so significant it needs to be moderated. Having said that, it is still over £4,300 for this year.

Imagine somebody graduating university having had their parents max out a Junior ISA returning the historical rate of equities. Not only that, but it would automatically roll over into a full ISA once the child hits eighteen. They are incredibly generous savings schemes for those who can take full advantage of them. Anyway, hopefully that covers the basics. The short version is yes, you absolutely should open an ISA.