There’s a new savings option available this tax year – the Lifetime ISA – aiming to help anyone aged 18 to 39 save for a deposit on a house, or for later in life, or both. It promises to be a useful product, but pensions remain the primary means for investing towards retirement.
What is a Lifetime ISA?
Available to UK residents aged between 18 and 40, it is possible to pay in up to £4,000 each tax year and continue making contributions up to the age of 50. The government will add a 25% bonus to each of these contributions, which means individuals who save the maximum will receive a £1,000 bonus each year from the government. As with a regular ISA, the money grows tax-free. Tax rules can change and any benefits depend on individual circumstances.
The accumulated pot can be used to buy a first home of up to £450,000 at any time from 12 months after opening the account. Alternatively, money can be withdrawn tax and charge free from age 60 for any purpose. Withdrawals before age 60 other than for a first property purchase are usually subject to a 25% government withdrawal charge.
How is the Lifetime ISA useful?
Rising house prices have made it increasingly difficult for young people to buy a first property. The Lifetime ISA can potentially provide a significant leg-up. Each individual under 40 is eligible to open a Lifetime ISA, meaning two first-time buyers (e.g. a couple) can use both of their LISAs when they buy together.
Alternatively, the Lifetime ISA could make a flexible alternative or addition to a pension, notably for self-employed people who want to save for retirement but are put off pensions because their money would be locked up until later in life.
What are the dangers of the Lifetime ISA?
Unlike Help-to-Buy ISAs, the forerunner to Lifetime ISAs in respect of helping first time buyers into the property market, the Lifetime ISA is available as Stocks & Shares as well as a cash product. While Stocks & Shares ISAs are usually most appropriate for those saving towards retirement, this is not necessarily the case for those saving for a deposit on a house.
The reason is the likely timeframe of the investment. Those with a long period over which to invest can afford to take more risk – and ride out the ups and downs of higher-risk investments such as shares, which tend to perform better over long periods. However, for those putting money aside for a house purchase, the stock market may be an inappropriate place to put their money. There is a danger that money earmarked for a house deposit could suddenly fall in value if the stock market goes down, which is why for shorter term goals financial advisers generally suggest people leave their money in cash.
There are also pitfalls involved in using a Lifetime ISA for retirement saving. Most importantly, it should not be used as a replacement for workplace pension, where you can benefit from employer contributions and potential National Insurance tax savings. This can translate to a ‘bonus’ on your money of over 100%, meaning that you could end up with far more invested than with the same level of contribution in a Lifetime ISA.
Another catch of the Lifetime ISA is the withdrawal penalty. The 25% ‘charge’ doesn’t just claw back the 25% bonus. If you put £4,000 into a Lifetime ISA and get the £1,000 Government bonus but then want to take your money out again, the 25% withdrawal charge will be £1,250 – even more if your chosen investments have risen in value.
Pension tax relief: a better option for saving for retirement?
For basic rate taxpayers the 25% Government bonus added to your savings in a Lifetime ISA will work out at the same as 20% pensions tax relief, so you will not get any more ‘bonus’ money in a Lifetime ISA than you would in a pension. However, LISAs do have the advantage that all withdrawals are tax free (from age 60), whereas for pension pots it is only the first 25%.
For higher and additional rate tax payers there is a clear incentive to favour pensions. The potential for tax relief at 40% or 45% results in a far more efficient way to build a retirement pot, and although pension income is taxable it can be taken on a flexible basis in order to maximise the tax efficiency of withdrawals.
Ultimately, we anticipate many people will choose to use both pensions and Lifetime ISAs at some point in their investing lives. A £4,000 annual Lifetime ISA limit gives limited scope for building a retirement pot, particularly for those closer to 40 than 18, but the annual contribution limits on pensions may also fall short of what some higher earners will wish to put aside.
The above article was first published by Charles Stanley on 26th April 2017.