The In's and Out's of LISA's
I love the Lifetime ISA – otherwise known as a LISA. I love it so much I want to talk about it at length and really drill down into some numbers.
First of all, I want to say that you should not hold all of your assets in a LISA. As with investments, you want your wrappers to be diversified. Some assets in a LISA, some in an ISA, some in a pension and some in good old taxable (non-wrapped) form.
What is the ‘Lifetime ISA’?
The lifetime ISA is a tax efficient investment wrapper as sponsored by the UK government. It is similar to a normal ISA in that it provides tax free investment income on the assets held within in.
How does it differ to a normal ISA?
In addition, and unlike other ISA’s, the UK government will add an amount of money to it, in proportion to what you add to it yourself.
What can I hold in a Lifetime ISA?
Broadly speaking, anything you can hold in a normal ISA (innovative ISAs are something different yet again). You can hold cash (getting interest), or stocks and shares (getting dividends and capital growth).
What can I put in?
You can put up to £4,000 per year into a lifetime ISA. This counts toward your total ISA allowance of £20,000. On top of the money you put in, the UK government contributes 25% of you contribution. So if you put in the full £4,000, you get a ‘bonus’ £1,000. If you put in £1,000 you get a ‘bonus’ £250.
You can only put cash in up to the age of 50, and only start a LISA by the age of 40.
Did you say tax free income earlier?
Yes I did. Any income or gain you make is tax free, both when it earnt and when it is withdrawn. That’s right, you get tax free gains and a bonus in investing. It is insane value.
This sounds too good to be true. What are the drawbacks?
The UK government gives such a great deal here because they are trying to affect your behaviour and get you to act in a way that you want. Unless you do what they want with the money, they are going to charge you a penalty to take it out of the LISA wrapper. This penalty is 25% of the money you withdraw, regardless of whether it is income/growth or even your original capital. Note that this 25% is more than the free money they give you (since £100 x 1.25 x 0.75 equals £93.75) so you are guaranteed to lose money on your original capital.
How do I avoid the penalty?
You get to keep the free money (and all of your own money) if you spend it in the way the UK government wants. You need to spend this money to buy your first home, or to save for retirement. If you’re using it as retirement savings, you need to withdraw it after the age of 60 or face the 25% penalty.
Why is it better/worse than a normal ISA?
To put it simply, its better because of the free money but its worse because of the withdrawal restrictions (assuming you would not spend the money in one of the two sanctioned ways anyway).
Why is it better/worse than a pension wrapper?
This one is a little harder to answer. Broadly, the rules behind pensions and ISA’s are very different, so it’s harder to compare which is better or worse.
In terms of ability to withdraw, pension money is locked until you are 10 years below state retirement age. Right now this is 55, but is due to increase to at least 57 by the time I (as a 30 year old) retire. Therefore, the age difference is minimal, but I can actually get at the ISA money if I need to, albeit while paying a penalty. Score one for ISA’s.
In terms of tax, when taking money out of a pension it will be taxed at your prevailing rate (either 0%, 20%, 40% or 45%). This will be a higher rate that you pay on removing cash from an ISA, assuming you have taxable income of more than your personal allowance (currently £11,000) per year – inclusive of the money paid from your pension. Its much more contextual, but (usually) score two for ISA’s.
Pensions do win out in bonus cash at least, as long as you’re a higher rate tax payer. You get tax relief (analogous to the LISA bonus) of 25% if you are a basic rate taxpayer and a 48% bonus if you are higher rate tax payer. (the official numbers are actually 20% and 40%, but this is based on gross figures rather than the money you pay in). Score one for the pensions (though again, a little contextual).
So the final score, depending on your personal situation will vary between 3-0 to LISA’s 2-1 to Pensions. This will primarily rely on whether you are a higher rate taxpayer now, and whether you intend to have taxable income in retirement.
So why am I such a fan of the LISA?
So the main drag is clearly the 25% charge on withdrawals outside of the sanctioned reasons. But is this really so bad? Let’s describe this as a tax for now, we can talk about effective tax rates in language we are used to.
First of all, let’s get the obvious out of the way. I do not want to pay that 25% tax. I want my free money (the bonus) and my tax free money – I want to have my cake and eat it too.
I will therefore do everything in my power to not draw any money from my LISA before my 60th birthday. I will draw from other assets, I will cut expenditure, I will do everything reasonable to stop the government taking their cut.
But what if that is still not enough. What if I have mis-allocated assets between ISA, LISA, pension and taxable, and I need to draw that money before I can draw money from my pension pot. What is the worst case scenario?
If I withdraw money from the LISA wrapper I will get ‘taxed’ 25%, which sounds like a big number. However, if I am higher rate tax payer I would get taxed 32.5% on the dividends and 28% on the capital gains. So effectively, I’m getting taxed at a comparable rate of income (assuming I’m already a higher rate taxpayer).
Since this is the worst case scenario, I’m probably not a higher rate tax payer or else I would not need this cash. So this actually wants to be compared to basic rate taxes, which are 7.5% and 18% for dividends and capital gains. This is more tax than I would be paying outside of an ISA, and so is clearly not ideal. But this ignores the fact that some (20%) of my LISA portfolio was generated from free money.
Using the same formula as earlier (which seems coincidental, but I have checked the maths thoroughly) I get 93.75 of my gains, giving an effective ‘tax’ rate of 6.25%. This is an entirely reasonable tax rate on my gains, as long as you don’t know there was a 25% charge involved.
How to really look at a LISA
It probably makes more sense to look at a LISA as a wrapper where all gains are tax by 6.25% if I withdraw them before I’m 60, but at this date the balance I have (£353,000 assuming I mazimise contributions and achieve a constant 7% return) is boosted by 25% and thereafter all withdrawals are tax free.
Also worth noting is that because this is not an actual tax, I do not get to benefit from any other tax breaks when paying it (such as my personal allowance or annual exemption).
So…long story short, I pay a 6.25% tax on all gains, unless I keep my portfolio until I am 60, at which point I get a 25% boost to my portfolio. While the government and media seems to have focused on the house buying side , I’m looking at retirement (since I already have a house). Even then, it seems pretty damn decent.
No wonder the maximum I can contribute is only £4,000 per year. I’m making out like a bandit already.