Individual Savings Accounts (ISAs) are brilliant financial products for saving and investing. By eliminating tax obligations, they can significantly improve someone’s chances of generating a healthy passive income.
However, with Cash ISA interest rates coming down, things are becoming more challenging for people planning for retirement.
I own one of these cash-based products. But I also own a Stocks and Shares ISA. And looking ahead, I think buying shares, funds, and trusts in one of these ISAs might be the better way to consider targeting a robust passive income.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
How much will I need?
It’s tough to know how much each of us will need to live on in retirement. The rising cost of living, along with uncertainty over the size and eligibility rules of future State Pension benefits, mean many of us could be putting away too much, or not enough, each month.
But it’s good to have a ballpark figure in mind. Let’s say, for instance, that someone is targeting a second income of £1,000 on top of their future State Pension.
This sort of figure could provide them with a decent standard of living in retirement. To achieve this, they’d need £300,000 in their ISA by the time they finished work.
That’s based on drawing down 4% of this amount each year. This drawdown rate would provide them with a passive income for roughly 30 years before their pot ran dry.
Getting to work
Unfortunately, achieving this goal could be tough with a Cash ISA. Based on the best-paying easy-access ISA currently available from Moneybox, it’d cost them a sizeable £504 a month over 25 years to hit this target.
That’s based on a 5% interest rate. But there’s danger with using this figure as a guide.
As I say, interest rates are falling again, meaning an individual may have to make even more regular investments to eventually achieve their £1k monthly second income.
Investing in a Stocks and Shares ISA can be riskier as markets go up and down. However, the higher annual returns they’ve regularly delivered could make this a better route to consider for retirement saving.
Let’s say that person invested regularly in a FTSE 250 tracker fund in a Stocks and Shares ISA instead.
If they chose this option, they could hit their £300k ISA target with a much lower £191 monthly contribution. That’s based on the FTSE 250’s long-term average annual return of 11%.
A top ETF
Past performance is not a guarantee of future returns. But products like the iShares FTSE 250 ETF (LSE:MIDD) have long proved an effective way of building substantial wealth while at the same time spreading risk.
They may, therefore, be a better option for risk-averse individuals who cherish the security of a Cash ISA.
By investing across the whole FTSE 250, exchange-traded funds (ETFs) like this provide exposure to hundreds of stocks spanning a multitude of sectors and regions. Therefore it can protect investors’ returns from troubles in one or two areas.
Furthermore, by investing cash across value, dividend, and growth shares, index funds like this can provide a smooth return across the economic cycle.
They may provide poorer returns than Cash ISAs during stock market downturns. But over the long term, funds like this in a Stocks and Shares ISA have proven an effective way of building wealth for retirement.
This post was originally published on Motley Fool
