Why Should I Invest In An ISA.. And When?

Why invest at all?

Ideally, we should all be saving, either for short to medium term needs [e.g. university fees, house purchase] or longer term needs [e.g. retirement]. For shorter to medium term needs,the combination of attractive tax relief and easy access to your accumulated monies, makes ISAs an ideal vehicle.

It is imperative for most long-term growth investors to save for a more comfortable retirement. State and company pension schemes are increasingly less likely to provide for a long and comfortable retirement, in part because people are living for much longer than they have in the past. Living longer is obviously good news but it does increase the pressure on us all to make sure that we have adequately prepared ourselves financially for a potentially long retirement.

Pension products, due to their advantageous tax status, are normally used to facilitate saving for retirement. However, investors should also consider the use of ISAs for their longer term saving needs, to supplement pension holdings. If you are nervous about the markets and the ongoing uncertainty in the economy, try not to let that anxiety override the practical need to invest.

The potential rewards from long-term investing have many benefits and, because there are so many investment funds, there should be something for everyone. There is more later on in this guide about how to choose the best investments to go in your ISA accounts, but it is important to think about what type of investor you are. You need to be realistic about how tolerant of risk you are and to be aware of your capacity to withstand loss of capital should markets depreciate.

When should I invest?

There is one easy answer to this question–as soon as possible–which can be arrived at in two different ways. First – because ISAs are a use-it-or-lose it tax break, delaying could mean you miss out on valuable tax savings. The annual contribution cap only lasts until the end of the tax year on April 5. When it’s gone it’s gone for ever – you can’t roll your allowance over from one year to the next.

The ISA is nothing short of a gift from the Chancellor which everyone should try and take full advantage of. Over the course of a long-term investment, the tax protection offered by an ISA could add thousands of pounds to your wealth that you would otherwise have had to pay in tax. If you haven’t got £10,200 to invest [or £10,680 for 2011/12 as per the latest ISA allowance 2011], you can consider switching less efficient investments into an ISA or start a monthly savings plan.

Second – if you delay, you risk missing out on the effect of compounding. To understand the power of this, think of twin sisters – let’s call them Prudence and Extravaganza for reasons which will become obvious – who, at the age of 18, make different financial decisions which change their lives completely.

Prudence, who listened when compounding was explained to her at school, decides to save a modest £1,200 a year – £100 a month - which she invests in a stock market fund, achieving a consistent return of 6% a year after all charges.

After 20 years, Extravaganza, who has been living it up in style and saved not a penny during the same period, sees how well her sister’s investments have been doing and decides she too wants to get a grip on her finances. She begins to invest the same amount each year and, again for the sake of simplicity, achieves exactly the same return after charges of 6% a year1. Just as Extravaganza starts saving, Prudence stops because she can afford to now. She never puts another penny into her investment fund but, like her sister, she continues to achieve an investment return of 6% a year on her investments.

Because of the effect of compounding, Prudence’s nest-egg grows to be worth over £168,000 over the 43-year period until both sisters are 60. Extravaganza’s is worth just £56,000, [around a third as

Much], even though by the end of the period she has actually contributed more than Prudence [£27,600 versus £24,000].