For most private investors, it feels pretty ambitious to set yourself the goal of building an investment portfolio worth £1 million plus, simply by making use of your annual tax-free ISA allowance. But it can be done, and indeed the first ISA millionaire emerged back in 2003 – long before allowances were anywhere near so generous – in the shape of Lord Lee of Trafford, a former Conservative minister in Margaret Thatcher’s government.
Lord Lee knew what he was doing. He achieved his target in just 16 years (using both ISAs and their forerunners, PEPs) by putting the maximum allowance each year into smaller UK company shares, often those listed on the Alternative Investment Market (AIM). In total he invested £126,000 in the process.
But how feasible is such an achievement for investors who don’t want to pick their own equities, or even to venture down the higher-risk end of the investment spectrum?
First, let’s consider why it makes sense to invest via an ISA in the first place. Investing in the market via an ISA has big advantages over the long term, as it removes your entire portfolio from scrutiny by the taxman. Not only is dividend income untouched but your capital can grow over the years without any risk of the gains being taxed when you eventually come to realise them – an important consideration for would-be millionaires.
“Thinking down the line, income from an ISA is tax-free, so it’s a brilliant way to minimise your tax bill once you stop working or are drawing an income from it to subsidise earnings.”
So, realistically, how long might it take to build up £1 million this way? If you simply stuck your £20,000 ISA allowance under the bed each year and left it there, you would need 50 years to reach your goal. But recent research shows that an investor who puts away that lump sum each year into an ISA investment paying a relatively conservative 5% a year could become a millionaire in half that time, thanks to the magical effects of compounding (whereby earnings themselves generate further earnings, and so on).
That would involve investing capital of £500,000. But the balance between initial capital, annual return and time required to meet your goal is an adjustable one: invest in an area with potential for greater returns over the long term but rather more risk of short-term dips, and you’re likely to achieve it in a shorter time and using less capital.
Taking the long view, many equity-focused fund sectors tend to return considerably more than 5% annualised. For example, the UK All Companies sector has returned an annualised 9% on average over the past 25 years.
Of course, as we are regularly reminded, past returns are no guarantee of future performance; but if we make the assumption that, while there will be ups and downs, over the next 25 years a comparable annualised return is achieved by funds in this sector, our ISA investor would require only 18 years and 10 months – and £380,000 of contributions – to achieve millionaire status.
Smaller companies, as Lord Lee was well aware, tend to outperform their larger counterparts over time, not least because it’s so much easier to grow rapidly if they get things really right. Thus, despite the fact that smaller companies are more likely to fail than large ones, the average UK Smaller Companies sector fund has returned an annualised 12.9% over the past 25 years.
If our ISA investor chose that option, then (again assuming comparable performance going forward) they would reach their goal of £1 million in just over 15 years and invest over £300,000. However, it’s highly risky to focus your entire portfolio on one asset class, let alone a single relatively volatile sector, so most sensible aspiring millionaires are likely to diversify at least geographically and by market capitalisation; they may hold assets other than equities as well, to mitigate risk.
Rather than investing a single lump sum of £20,000, it may be easier or more realistic to make regular contributions out of income over the year. Investing the full allowance over the year would involve monthly payments of £1,666.
Saving regularly means you’re not fully invested from the start of the tax year and may in some market conditions take rather longer to reach your goal. Against that, it enables you to benefit from the effects of pound-cost averaging, whereby your money buys more units in months when prices are low and fewer when prices are high. Buying at a variety of prices and spreading ongoing investments over time reduces risk by helping to cushion your portfolio from the full impact of dips in the stock market.
Of course, such a discussion does raise the key question: is maximising your ISA really the best thing for your long-term finances? Thinking down the line, income from an ISA is tax-free, so it’s a brilliant way to minimise your tax bill once you stop working or are drawing an income from it to subsidise earnings. £1 million invested to produce a 4% yield would boost your cash flow by £40,000 a year, totally free of tax.
But if you have access to a workplace pension, and particularly if you have an employer who makes generous contributions to it, paying into a pension is in most cases ultimately more tax-efficient, even though you’ll pay tax on 75% of it when you come to make withdrawals.
There are, however, some groups who could very sensibly set their sights on ISA millionaire status. Most obviously, if you are a member of a salary-related pension scheme and will have the security of a guaranteed income (or the option of an attractive transfer offer out of the scheme), focusing on your ISA will give you more flexibility in terms of income in years to come.
If your pension fund – whatever form it takes – is likely to exceed the £1 million lifetime allowance in coming years, or has already done so, it certainly also makes sense to maximise annual ISA contributions. Finally, there’s nothing to stop retirees ploughing any spare cash into their ISA, even though only the very comfortably- off will have a spare £20,000 to tuck away each year.