The 5% ISA challenge

The value of your investments and the income you receive from them can go up and down, and you may get back less than you invest. Any examples are for illustration purposes only. ISA eligibility and tax rules apply.

Before we get into it, a confession. When I read an article telling me how much better off I’d be if I just saved or invested more, my eyes start to roll all by themselves. It’s hardly a eureka moment, is it? If we all had enough to max out our ISA every year, we’d be doing it already. The reality isn’t that we’re all sitting on piles of cash and spending it on [insert outdated breakfast menu item here] instead of putting it to work for our future. Young people are increasingly worried about their finances, as The Young Persons’ Money Index shows us.

“81% of young people in our survey said they worry about money or personal finances, compared to 60% in 2016.”

The Young Persons’ Money Index 2023/24, The London Foundation for Banking & Finance [1]

So, how does all of that fit with what you’re about to read, which is all about what could happen to the investment returns in your stocks and shares ISA if you up your current monthly contribution by 5%?

Well, if it comes across like I want it to, it’ll be much more empowering and a lot less condescending. The main goal here is to demonstrate how investing consistently over the long term can help, as well as how small changes now can have big effects later on. It’s also about detailing what that bit extra could achieve if you get that promotion (congrats in advance) or are thinking about diverting some regular cash savings into investments.

The last thing it hopefully shows is how useful the ISA tax wrapper is. Its whole purpose is to help us invest tax efficiently, meaning we don’t pay UK capital gains tax or UK dividend tax on any gains we make inside it. That benefit becomes more pronounced the more we invest and the longer we leave it all to compound.

Let’s say we have a 30 year-old who wants to pay off their mortgage in 30 years without dipping into their pension. Maybe it’s more about building a pot to bridge the gap between working life and the state pension kicking in. Whatever the goal and their ability to invest, the evidence is clear that little changes now can snowball over time.

In our examples, we’ve used three different monthly investment amounts that ISA investors might target, raising each by 5% to see what happens. We’ve assumed an annual rate of return of 7% in line with the S&P 500’s historical average. It would be remarkable and a bit suspicious if the next 30 years delivered 7% exactly - volatility is a natural part of investing after all - but it gives us an informed figure to work with.

So, the results:

Hypothetical example based on monthly investments, compounded once per year, over 30 years. Past performance is not a reliable indicator of future results. When you invest your capital is at risk.

For those of us to whom a bunch of numbers in a table creates more confusion than clarity, here are the main takeaways:

• For our £250 investor, upping their contributions by £4,500 over 30 years (£12.50 each month) could mean an extra £14,624 at the end.
• For our £500 investor, upping their contributions by £9,000 (£25 each month) could mean an extra £29,248.
• For our £1,587.30 investor, upping their contributions by £28,570 (£79.36 each month) could mean an extra £92,843.

The reason small changes can really rack up over the long term is down to that most basic of elements when it comes to investing: compound interest. Giving your interest the chance to earn interest of its own is a core building block of wealth creation and its effect is amplified the longer you leave it.

For fairness, we can compare the above to cash savings only with the proviso that we understand the difference in risk between the two. Investing brings in the potential of losing the money we begin with and, while more stable day to day, saving cash carries the risk that our growth rate doesn’t keep up with price rises in the shops (inflation).

With that in mind, here’s what cash might have given us, if we use its 2.3% average annual return from the past 30 years [2] as a guide:

Three-month US Treasury bills as a proxy for cash, 1994-2023. Sources: Ritzholtz Wealth Management, A Wealth of Common Sense [2].

The prospective uplift in future value is noticeably more muted than in our first example and for good reason. That lower annual rate of return (2.3% vs 7%) reflects a more stable journey - that’s the trade off, after all. Cash also comes in handy in case the boiler blows, so this isn’t to say it’s useless - just that it’s likely to underperform stocks over the long term.

Hypothetical example based on monthly investments, compounded once per year, over 30 years. 7% assumed annual rate of return for stocks, 2.3% annual rate of return for Three-month US Treasury bills as a proxy for cash, 1994-2023. Past performance is not a reliable indicator of future results. When you invest your capital is at risk.

Just to reiterate, though, this isn’t scaremongering or chastising people for not saving enough. Nor is it a sign to funnel your every penny into the stock market without a thought to risk management or upcoming expenses. We need investing to be a healthy part of our finances and the more we put pressure on it all, the more we’re likely to seek too much risk or resent the whole thing. Instead, it hopefully backs up the decision for those who have been thinking about investing more, in the knowledge that history shows us it can potentially result in a worthwhile payoff.

Maybe the most noteworthy takeaway here is maths of a different kind. Given the current annual UK capital gains allowance of £3,000 and UK dividend allowance of £500 (and our returns here which are considerably higher than that) investors squirreling away monthly amounts over the long term could be hit with a sizeable tax bill if they didn’t use their stocks and shares ISA.

What’s more, as these rates are applied according to our income, we could end up paying more tax if we start to earn more and break into the next income tax bracket. It paints a picture of penalising your savings and investments more as your earnings increase, which is unlikely to feel attractive. The good thing is we can make sure our investments are tax efficient by using our stocks and shares ISAs consistently and, where possible, maybe even adding that extra 5%.

Sources:

[1] The Young Persons’ Money Index 2023/24, The London Foundation for Banking & Finance, August 2024 [2] A wealth of common sense; 30 years of financial market returns, April 2024

Important information

When investing, your capital is at risk. The value of your investments, and the income you receive from them, can go down as well as up and you may get back less than you invest. Forecasts aren’t a reliable guide to future results or returns.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information and does not constitute any financial advice. This is not an offer, recommendation, inducement or invitation to buy, sell, or hold any securities, or to engage in any investment activity or strategy.

Robinhood doesn’t provide tax advice. You should seek advice if you have any questions regarding the impact your investments will have on your income tax and tax filing requirements.