The recent performance of the stock market has been disappointing. Yet for long-term investors, the reality could look quite different and possibly rather positive. In recent articles I’ve written about how regular investing over several decades can lead to great wealth for the average person. And today I’d like to discuss how a Junior Individual Savings Account (ISA) may offer a viable way to invest for the future of the young members of your household.
What is a Junior ISA?
Our government describes Junior ISAs as “long-term, tax-free savings accounts for children”. In the 2019–20 tax year, the savings limit for Junior ISAs is £4,368. The allowance must be used before midnight on 5 April. The next day, the new tax year begins and we have a reset.
What can you buy in a Junior ISA? You have two options:
- a Cash Junior ISA, or
- a Stocks and Shares Junior ISA.
How you’d invest in part depends on your risk tolerance. Yet before you go all-cash I’d recommend considering buying shares too.
Interest rates are currently at an all-time low in the UK. A quick internet search shows that Junior Cash ISA rates currently stand around 3%.
On the other hand, my Motley Fool colleagues who regularly cover FTSE 100 and FTSE 250 shares and funds, point out that despite various downturns and even crashes, over the long run, stock markets in the UK return about 7% to 9% annually, on average.
And that difference in the annual return over the long haul is likely to make a big difference in the final amount. Here’s why.
The miracle of compound interest
Compound interest has a snowball effect on personal savings. As time goes on, interest leads to more money, over and over again.
Let’s assume you’ve a 2-year-old and you’d like to invest £2,000 in a fund now with additional £2,000 contributions annually at the end of each year. The time horizon is 15 years.
The annual return is 3%, or about the return on a Junior Cash ISA, compounded once a year. At the end of 15 years, the total amount saved becomes £40,313.
But if the annual return increases to 7%, or the about the long-term average stock markets have returned over time, the amount becomes £55,776.
Now, let’s project these figures into the future. Your child, who is a young adult takes the above amount and opens an ISA that is designed for adults.
Let’s assume he or she also invests an additional £5,000 a year, at the end of each year.
The fund that initially had £40,313 gets invested in a Cash ISA, which right now pays about 1.3%. Including the annual £5,000 contribution, at the end of another 35 years, when your child will be in the mid-fifties, the total amount becomes £283,184.
On the other hand, the fund that initially had £55,776 gets invested in a Stocks and Shares ISA for 35 years. And we’ll assume the average return is again 7%. The amount grows to £1,286,681.
In other words, the difference between the two funds is rather staggering. So even if the current market downturn is making you nervous, I’d still like to encourage you to think long-term and consider including stocks and shares in a Junior ISA.
Finally, if you’re unsure about selecting individual companies due to increased uncertainty an industry may face, then you could buy into a FTSE 100 tracker fund.