Are Lifetime ISAs really worth it?
Are Lifetime ISAs worth it?
Lifetime ISAs (Individual Savings Accounts) are a government-backed savings scheme designed to help younger adults save for their first home or for retirement. They also offer a 25% bonus from the government of up to £1,000 per year. But who are LISAs designed for and is there a catch to free money from the government? Rupert Lovesy explains if they are worth it in this latest article.
What is a lifetime ISA (LISA)
Lifetime ISAs are a special type of Individual Savings Account (ISA) announced in George Osborne’s 2016 budget which promised to “put the next generation first”. They were introduced to incentivise people aged 18-40 to save for a first home or for retirement, with generous government bonuses.
With a Lifetime ISA you can save up to £4,000 a year, and the government adds a 25% bonus - up to £1,000 every year until you turn 50.
You can open either a:
- Cash LISA, which works like a normal savings account with interest, or a
- Stocks and Shares LISA, where your money is invested and can go up or down in value.
Any money in a LISA grows tax-free, just like with other ISAs.
What’s the offer?
18-40-year-olds can take out a Lifetime ISA (LISA) as part of their £20,000 annual ISA allowance. They can put in up to £4,000 in a tax year and receive a 25% bonus. That’s up to £1,000 of subsidy, and once the account is open, you can do this every year until you are 50. You can opt for cash or stocks and shares LISAs and, in line with other ISAs, the funds are completely free of tax on dividends, interest, or capital gains.
However, there has been considerable controversy regarding the penalty applied if the funds are not used according to the rules. If you make a withdrawal within 2 years of opening the account or for a purpose other than buying your first home (under £450,000), for retirement (beyond age 60), or following a diagnosis of a terminal illness, that withdrawal suffers a 25% penalty.
there has been considerable controversy regarding the penalty applied if the funds are not used according to the rules
Is there a catch?
Yes. And the penalty can sting.
If you save £4,000, you’ll get a £1,000 bonus, bringing your total to £5,000.
But if you withdraw it for a reason not allowed (e.g. buying a car or paying off debt), you’ll pay a 25% penalty on the full £5,000. That means you get back £3,750—£250 less than you originally saved.
Why? Because the 25% penalty applies to the full amount, not just the bonus.
That’s a poor outcome and has put a lot of people off! It’s not helped that many people actually don’t understand why if they got a 25% uplift and then pay a 25% penalty they are not in the same position as had they not had the bonus.
An easier way to think about this is putting in £4,000 gives you 80% of the total. So if you lose 25% of the total as a penalty, you’re left with only 75%.
There obviously has to be a way to prevent the LISA system being abused, but many have argued that this seems particularly unfair and disadvantages those who are less well-off and have a higher chance of needing to withdraw the funds for a more pressing need.
When a LISA can work for you
Interestingly, in a recent study by Ipsos into the use of Lifetime ISAs, the penalty was actually seen in a positive light by some savers as they saw it as a deterrent against early withdrawal.
If you’re planning to buy your first home or save for later life, a LISA can give your savings a big boost.
But you’ll need to leave the money in there for a while to really benefit. If you withdraw it early for anything else, you could lose money.
If you’re planning to buy your first home or save for later life, a LISA can give your savings a big boost.
Breaking Even - Cash Savings Example
In order to break even, if you needed to make a withdrawal outside of the criteria, you would need your £5,000 to grow to £5,333.33 - a modest annual interest rate of 3.28%.
Let’s say you open a cash LISA and save £4,000
- Add the bonus: +£1,000 = £5,000
- Interest at 3.28% a year = £5,333 (after 2 years)
- Withdraw early (not for a house or retirement):
o 25% penalty = £1,333
o You get back: £4,000
In this case, you just break even. But you would have done just as well (or better) putting your £4,000 in a regular cash ISA with no penalty risk.
Obviously, this calculation gets more complicated if we are considering each year’s contribution separately or making monthly savings rather than a lump sum, but this is a good starting point.
Unfortunately, if you are breaking even, you’ve not done as well as had you not had the government bonus in the first place, as you could have deposited £4,000 in an ordinary ISA at that interest rate and kept all of the interest (£266.70) for yourself.
This suggests that if you held a LISA for a short period of time in cash savings and then used the whole amount for something that didn’t meet the criteria, you could make a loss, so you have to weigh up the risk of that when choosing ISA or LISA.
On the other hand, if you did actually use the withdrawal from a LISA within the set criteria after 2 years, you would have been £1,066.68 better off.
What about investments?
Investments offer much better potential for growth over the long term, but you are required to take a risk. There are lower risk and higher risk investments but all of them can go up or down in value, meaning you could end up with less than you started with. This risk is higher the shorter the term of the investment and for that reason, you shouldn’t generally invest funds you are likely to need within 5 years.
If you experienced investment growth of 5% year on year after charges for 5 years (please bear in mind that investment growth will vary hugely each year and may sometimes be negative), your £5,000 would be worth £6,381.41. But if used for something outside of the criteria, you would receive £4,786.06, which is still more than you put in. Had you just put £4,000 in an investment ISA, though, it would have grown to £5,105.13
For the example above, but for 10 years, your £5,000 would be worth £8,144.47 or £6,108.35, if subject to a penalty, but your £4,000 in an ordinary stocks and shares ISA would be worth £6,515.58.
You will recall that I mentioned you could end up with less than you started with – what if that happened? Well, ideally you would not withdraw it when it was worth less than you put in but life doesn’t always work out the way you planned, so with that in mind, if your £5,000 had dropped to £4,000 and you made a withdrawal, you would get £3,000 if subject to a penalty, which is a loss of £1,000 on what you originally put in. However, if you had put £4,000 in an ordinary stocks and shares ISA and it had dropped by the same percentage, it would be worth £3,200, so you would have lost £800
Due to the inherent risk of investments, it’s important to review them regularly and to reduce your investment risk as you get nearer the time you are likely to need the money, so that it is less likely that a big drop in value will compromise achieving your goal.
Is inflation a problem?
Inflation has been very high in recent years, and it reduces the value of your savings in real terms. If inflation was 3% and you got a 3.28% return on your savings, it would be like getting a return of 0.28% in terms of the increase of your spending power. Often the interest rate is actually lower than the rate of inflation. For that reason, cash savings give the risk of the real value of your money being eroded over the longer term.
What if I take a loan and invest it to get the bonus?
Borrowing money to invest is generally a bad idea. You pay interest on the money you borrow and if the value of your investment reduces below the amount you owe, you will not be able to pay the money back when you need to. Apart from anything else, having a good credit record is important for getting that mortgage on your first home!
What if I don’t need the full amount for a house deposit?
If you are lucky enough to have saved more than you need for a house deposit, you could either leave the remainder until after age 60, when you can take it without penalty, or suffer the penalty on the amount that will not form part of your deposit.
Conclusion
LISAs can make a lot of sense if you are saving towards a first home that you will purchase in several years’ time and have money set aside separately for emergencies. You should consider carefully whether cash savings or investments make sense for your own situation in order to balance the risks of inflation and fluctuations in investment values. If there’s a reasonable chance your savings will not be used for a house purchase or retirement, then you are likely to be better off with a conventional cash or investment ISA. You can even transfer funds directly from an ISA to a LISA should you want to later on.
Written by Rupert Lovesy
With investment, capital is at risk.
Sources:
Understanding the use of the Lifetime ISA: qualitative research - GOV.UK