The tax year has just started, and it might be worth using your tax-free investment allowances. James Norton, head of financial planners at Vanguard, explains why.
A new tax year has begun and with it the chance to make early use of your 2022/23 tax-free investment allowances.
You may be thinking: why hurry when there are still 12 months still to go? But the counterargument is, why delay when your chances of investment success improve the more time you are invested?
Or as we like to put it: it’s time in the market – not market timing – that counts.
In fact, you could potentially lose up to £40,000 over 25 years by waiting until the end of each tax year to invest, rather than investing at the start.
Consider what would happen, for example, if today you invested the annual maximum of £20,000 in an Individual Savings Account (ISA) and another £20,000 each subsequent year, on the very same day, earning a hypothetical annual investment return after costs of 4.5%1.
In this scenario, you'd end up with more than £931,000 in your account by the end of your 25th year – broadly £500,000 of invested capital and another £431,000 in growth.
Wait until the end of this tax year and every subsequent tax year to invest the same amount of money, though, and you would end up with just £391,000 in capital growth.
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So, if you have a lump sum of money (virtually) collecting dust in a bank account that is more than your emergency cash fund and part of your long-term savings, why not put it to work in the market sooner rather than later via your ISA or Self-Invested Personal Pension (SIPP)?
Similarly, if you don’t have a regular contribution plan set up, it’s worth considering doing so and if you do already have a regular payment plan, it might now be a good time to increase the rate at which you contribute each month.
With the start of the new tax year, everyone has a new £20,000 ISA allowance. For under 18s, there’s also a new £9,000 Junior ISA allowance.
This means you can invest this money in shares and bonds, up to the respective caps, and not have to worry about paying tax on any of the income or capital gains you might make on these investments.
It potentially gets even better with a SIPP – always assuming, that is, that you’re happy to lock in your money until you’re at least 55 (rising to 57 in 2028).
This is because you not only pay no tax on your investment earnings, as with an ISA, but you also get tax back on your pension contributions2.
You can invest 100% of your annual earnings up to a maximum of £40,000 each tax year into your pensions (and you can carry forward unused pension allowances from the previous three tax years too)3.
It’s never too soon to invest – but it can sometimes be too late, depending on your goals. Because the less time you give your investments, the less potential there is for compounding to work its magic on your behalf.
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What is compounding?
Compounding helps your investments to grow more quickly by paying a return not just on the money you invest but also on all the money you previously invested and on the money that, in turn, you made on those earlier investments.
It’s akin to a sort of snowballing effect.
Of course, the potential for your cash savings to compound is not what it used to be. We all need cash for emergencies but with interest rates as low as they are, your cash savings aren’t going to grow that quickly even with compounding.
But it’s potentially a different story if you invest your money through a Stocks and Shares ISA or SIPP. This is because the potential return from shares is greater.
It’s not guaranteed, of course, that you'll make money in a Stocks and Shares ISA as the value of your investments can fall as well as rise, which means you could potentially get back less than you put in.
But Vanguard’s economists, based on their latest internal modelling1, believe UK investors can expect annualised average returns over the next 10 years of between 4.2%-6.2% in the case of UK shares and from 2.5%-4.5% for overseas shares.
So now a new tax year has started, why waste a year by leaving it until the last day to invest in your ISA when those extra 12 months could make a big difference to your wealth in the long run?
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This article was written by James Norton, head of financial planners at Vanguard. The views expressed in this article do not necessarily reflect those of loveMONEY
1 A figure that assumes annual costs of 0.5% and long-term returns of 5% is broadly in keeping with the projections of the Vanguard Capital Markets Model (VCCM), our proprietary financial simulation tool. The projections are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The model forecasts distributions of future returns for a wide array of broad asset classes and are derived from 10,000 simulations for each modelled asset class. Simulations are as of 31 December 2021.
2 The basic-rate tax is paid back in the form of a top-up that is automatically added to your SIPP after about 6 to 11 weeks. Higher-rate and additional-rate taxpayers can claim back more through their annual tax returns.
3 The allowance covers all your pensions, including workplace schemes.