How ISA tax benefits can potentially improve investment returns over time

ISAs, or Individual Savings Accounts, are a simple way to protect your investments from tax. And the financial benefits of investing tax-efficiently via an ISA have the potential to mount up over time.

To illustrate this, we have compared hypothetical returns from a £10,000 investment portfolio held in a stocks and shares ISA versus the same investment held in a taxable general investment account (GIA).

For the sake of simplicity, we have assumed the portfolio generates an annual return of 5 percent. We assume the investor would be subject to tax at 40 percent, which is the higher rate of income tax, and that the returns are themselves reinvested in the same portfolio. We have also assumed there are no market downturns, which would be highly unlikely but keeps things simple for this example.

We show the difference in returns between an ISA and a GIA over a 25-year timeframe and, as the chart below shows, the difference is striking.

How the tax-efficiency of ISAs can boost portfolio returns

Source: Schroders Personal Wealth

After five years, the return from the ISA portfolio would have been £2,763, while the GIA’s post-tax return would have amounted to just £1,593. After 15 years, the ISA portfolio would have returned £10,789 while the GIA’s net return would have been eroded by tax to stand at £5,580.

After 25 years the disparity between these portfolios’ different levels of tax efficiency becomes more pronounced. At this point, the ISA’s total return is £23,864 while the GIA’s is £10,938. So the gains on the tax-efficient ISA portfolio here amount to more than twice that of the taxable GIA portfolio.

Benefits of compounding

The widening in the difference in returns for longer time periods is due to the impact of the reinvested returns, an effect known as compounding. Quite simply, the tax-efficient ISA portfolio reinvests larger returns than the taxable GIA investment (where the returns are reduced by the 40 percent higher tax rate). In turn, these reinvested returns themselves make greater returns in an ISA than in a GIA.

This is a purely hypothetical example. For a portfolio to return 5 percent a year consistently for 25 years would be highly unusual. After all, markets can be turbulent so investments fall as well as rise in value. Stocks and shares ISAs don’t protect portfolios from market movements and a stocks and shares ISA may go down in value.

What this example does highlight, though, is the corrosive impact of tax on potential returns. Should you be able to generate a 5 percent annual return, you would want to try to keep all of these gains. Protecting this from tax is a simple yet important step that can make a big difference in the returns you achieve.

At Schroders Personal Wealth, one of our key principles is to invest for the long term. Being able to protect your investment from tax as much as possible is therefore very important in the wider context of your finances.

Different tax rates

In this simplified example, we have assumed for illustrative purposes that you would be liable for tax at the 40 percent higher rate of income tax. But you could, instead, be liable for the 20 percent basic rate of income tax. And your investment returns in a GIA may also benefit from the annual tax-free personal allowance. In these cases, the disparity in performance between the ISA and the GIA could be smaller.

The investment portfolio could also be liable for capital gains tax and dividend tax, which have different rates from income tax. So the amount of tax you would be liable for in a GIA could be a blend of these rates.

Moreover, we all have annual capital gains tax and dividend tax allowances. As long as you don’t exceed the allowance thresholds, your capital gains and dividend payouts could be tax free even in a GIA.

In the end, ISAs can play a key role in financial planning, due to their tax-efficiency. But GIAs can also have their place, depending on your individual circumstances. A good financial adviser can help you fit ISA investments into an overall financial planning strategy and help select a portfolio of other investments appropriate for your circumstances.