Your ISA can make you a millionaire!

With stubborn saving over the years, your tax-free ISA can reach a mighty total.

The UK’s most popular tax shelter is the Individual Savings Account, or ISA. Over 19 million of us have an ISA, which we use to keep our income and capital gains free from tax.

I say, I say, ISA

Although an ISA may appear complicated (and one in 10 young adults thinks it’s an energy drink!), it’s actually very simple. An ISA is simply a tax-free wrapper to keep investments away from the taxman. Inside your ISA, you can put money on deposit, or invest it in shares, bonds, index trackers or other funds - whatever takes your fancy.

Of course, there are limits as to how much you can put into an ISA. Each tax year (which runs from 6 April one year to 5 April the next), you can put up to £5,100 into a cash ISA. On top of this, you can put up to a further £5,100 into a stocks and shares ISA, for a total yearly limit of £10,200.

If you don’t want to save in cash, then you can put up to £10,200 into a stocks and shares ISA. Also, cash ISAs are available to UK residents aged 16 and over, but you need to be 18 or over to have a stocks and shares ISA.

Watch your ISA grow

As with all financial planning, it’s best to view your ISA as a long-term home for your savings. Indeed, if you can save for decades, then your ISA can grow into a handsome nest egg.

Let me show you how: we’ll start by assuming that you can afford to pay in the maximum £5,100 a year into a cash ISA. You do this by depositing £425 a month for year after year after year. Here’s how your money would grow at three different interest rates and four different periods:

Paying £425 a month into a cash ISA

As you can see, it’s just about impossible to become a millionaire by saving inside a cash ISA, even if you put in the maximum £5,100 a year and save for four decades.

What’s more, with the Bank of England’s base rate stuck at an all-time low of 0.5%, there’s no way you can earn 4% a year in any new cash ISA. Indeed, even the best long-term fixed-rate ISAs pay 3% a year or less.

So, unless you plan to live a very long life, then you can forget about having a million inside a cash ISA. If you’re serious about hitting the £1,000,000 mark, then you have to take some risk by investing in companies via the stock market.

There are two advantages to putting money into a stocks and shares ISA. First, the yearly limit is £10,200, which is twice as much as you can put into a cash ISA. Second, by investing in shares, you should produce superior returns to cash over decades.

So, let’s look at how your ISA would grow if you could afford to pay in the maximum £10,200 a year:

Paying £850 a month into a stocks and shares ISA

As you can see, being able to pay in twice as much (£10,200 versus £5,100) and exposing your money to the higher long-term returns on offer from shares makes a ‘share ISA million’ a real possibility.

Indeed, investing £850 a month for 40 years at 4% would produce just short of a million. However, at 8%, the same monthly sum produces a pot worth nearly £2.8 million. This demonstrates the awesome power of compound interest piling up over decades.

Now for the bad news!

The expression “A million ain’t what it used to be” certainly applies here.

In other words, today’s £1,000,000 buys you a lot more than the same sum forty years from now in 2050. This is because inflation - the rising cost of living -- erodes the value of your money over time.

For example, inflation of 3% a year for 40 years would more than triple the price of today’s goods by 2010. In this scenario, you would need £3.26 million in order to have the same purchasing power as £1 million today.

Nevertheless, I can think of nothing more important financially than saving and investing over the long term (apart from paying off expensive debts, that is). By starting to save as early as you can, and putting aside as much as you can, you’re bound to enjoy more freedom and control in later life.

At the end of the day, that’s what we all aspire to!

More: Start your ISA today! | Great news for your ISA | Help! In my forties and still no pension!