To achieve £100,000 in ten years required monthly contributions to be set at £642. The lower line represents the total that has been contributed over the ten years, while the higher line shows the total fund size including any investment gain.
By the time ten years are up, the fund has grown in size to £100,107. There would have been £77,040 of contributions made in that time, with the remainder – some £23,067 – being generated from investment returns. That means almost a quarter of the total fund at the end has come from investment gains.
Escalating your contributions
A tweak on this exercise is to steadily increase the size of monthly contributions each year instead of maintaining them at the same level. In doing so, it is possible to set monthly contributions at a lower level at the start and then raise them gradually.
This can be a useful way to approach long-term saving because it mirrors how our ability to make contributions changes over time. If you are working and earning a salary it is normal for your pay to rise as the years go by, meaning you should be able to contribute gradually more. In practice, this can mean tweaking your contributions higher each time you get a promotion or a pay rise at work.
Assuming the same investment return, we found it was possible to start monthly contributions at just £567 and then increase these by 3% a year – to reflect annual wage rises – and then achieve a total investment fund of £100,132 after ten years. In that time, contributions will have totalled £78,001 meaning £22,131 would have been generated from investment gains.
Where to do it?
Being tax efficient is an important part of investing success in the long term. In our scenarios, substantial sums have been generated through investment returns which could be subject to tax unless arranged correctly.
Thankfully there are simple ways to do it. ISAs – or Individual Savings Accounts – are designed with this purpose in mind.
For savings intended for retirement, pensions are another way.
ISAs allow up to £20,000 to be contributed to savings or investment each year and any return made from those contributions – including any income they pay – will be free from tax.
Returns on investments held outside an ISA – such as an Investment Account – are potentially subject to Capital Gains Tax (CGT) – charged at 18% for basic rate taxpayers and 24% for higher-rate taxpayers. There is an annual allowance for gains of £3,000 before CGT applies.
In our example, where £23,067 of gains have been made over ten years, CGT totalling £5,536 (£23,067 x 0.24) could be due, assuming no allowance is available and the individual is a higher rate tax payer. Investing inside an ISA means you can avoid this.