People sometimes talk about Stocks and Shares ISAs and their possible tax advantages, without getting into the detail of how an ISA might actually help someone as they aim to build wealth.
So, does it work?
Long-term capital gains
Perhaps the simplest way to understand how someone might build wealth in a Stocks and Shares ISA is if they are able to sell shares for more than they buy them. This is known as a capital gain.
That might happen over the short term, but as an investor — not a trader — I aim to buy shares and hold them for the long term.
To illustrate, Rolls-Royce shares have gone up 52% over the past year, which is certainly very impressive. Over five years, though, they are up 997%.
So, if someone invested £1,000 in the shares five years ago, they could sell them today for around £10,970.
If they do not sell, that is their ‘paper gain’. But a paper gain (or loss) does not crystallise until the shares are sold.
The actual capital gain can be reduced due to the difference between buying and selling prices at the same time (known as a spread). The spread can be significant, especially on thinly traded shares.
Fees and commissions can also eat into returns, so it makes sense to choose carefully when picking a Stocks and Shares ISA.
Dividends can provide a steady stream of passive income
Another way an ISA can help someone build wealth is through dividends. Whether that happens depends on what shares they own in the ISA.
Not all shares pay dividends and, even when they do, they are never guaranteed to last. That said, some have paid dividends year after year – Scottish Mortgage Investment Trust has not cut its payout per share since the aftermath of the Wall Street Crash close to a century ago!
Aiming for a snowball effect
A different approach is leaving the dividends inside the ISA wrapper, increasing the amount of money available to buy new shares (and potentially earn more dividends) without eating into the annual ISA contribution allowance.
That is known as compounding. Investor Warren Buffett compares compounding to a snowball rolling downhill. The further it rolls, hopefully snow (dividends) will pick up more snow and so on.
Buffett is a fan of compounding in general. But one reason it can be especially helpful in an ISA context is that by allowing the dividends to be kept inside the ISA wrapper, an investor could potentially end up being able to invest more cash within their ISA each year than their contribution allowance alone would suggest.
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.
A share to consider
One share that I think offers both capital gain and dividend potential over the long-term is Pets at Home (LSE: PETS). I see it as a share worth considering.
After falling 58% in five years, the share now sells for just 11 times earnings.
I reckon that is attractively valued for a large, profitable company with ongoing growth opportunities. The dividend yield is a tasty 6.9%.
That price fall suggests trouble, though. The company’s shop sales performance in the past several years has been disappointing. There is a risk that could continue, hurting profits.
But a turnaround plan is in progress. Meanwhile, the vet practice division continues to grow.
