The new Lifetime ISA

Available from April 2017, the Lifetime ISA is designed to help the younger generation save towards their first home and their retirement. It can be set up by those aged 18 to 40 and contributions will be limited to £4,000 a year and will count towards the overall £20,000 yearly ISA limit. Any contributions made before the age of 50 will benefit from a 25% government bonus – if the maximum contribution is made in a tax year, this is equal to £1,000.

Withdrawals will be tax-free in three circumstances:

  • For use towards the purchase of a first home worth up to £450,000 (provided funds are not withdrawn in the 12 months after opening an account),
  • For use in retirement from age 60, and
  • For those diagnosed with a terminal illness.

Withdrawals before such a time are possible, however the government bonus will need to be repaid (including any investment return on this) and a 5% charge will be levied on the remainder.

On death, any funds will be treated in the same way as standard ISAs, i.e. they are included in the estate for Inheritance Tax (IHT) purposes. But as per current ISA rules a surviving spouse/civil partner can utilise the ISA value at date of death to make a one off payment into their own ISA and rely on the inter-spouse exemption to avoid a liability to IHT.

Further detail is still expected and the government are considering whether tax-free access should be available for other specific life events and whether to allow borrowing from the fund without losing the bonus, similar to plans available in the US.

There has also been no detail on the decumulation options available in retirement. For example, it is not clear whether it will be possible to use the fund at age 60 to purchase an annuity within the ISA – the announcements state that qualifying investments will be the same as per current cash and stocks and shares ISAs, these rules currently specifically prohibit an annuity as an investment.

Whether or not an individual is better off in the Lifetime ISA as opposed to a pension depends on a variety of factors, including their marginal tax rate during their working life, their marginal tax rate in retirement, the level of employer contributions available and whether pension contributions are made on a salary sacrifice basis or not.

One point where the Lifetime ISA definitely wins over a pension is the charges made for early withdrawal. In the Lifetime ISA, the 25% government bonus and any investment return on the bonus are repaid and a 5% charge on the remainder, making a total of 24%. Total unauthorised payment charges, including scheme sanction charges on a pension would come to 70%.

The Lifetime ISA does not give access to retirement savings until age 60, whereas the Normal Minimum Pension Age (NMPA) is currently 55. But the 2014 Budget announced that the NMPA will be directly linked to increases in the State Pension Age (SPA) and those that are 40 when the Lifetime ISA is introduced next year are unlikely to be able to access their pensions until they are at least 57 anyway. (Note that the legislation linking the NMPA to the SPA was expected in the Taxation of Pensions Act 2014, however it was not included so it could be that this policy will now be withdrawn).

One of the reasons ISAs have been so popular is that the rules are relatively straightforward. Pension legislation has evolved over many decades and even pension simplification hasn’t really simplified that much. Arguably, some of the complexity is necessary though, such as pension sharing on divorce and the protection afforded to pensions in bankruptcy. You would therefore imagine that equivalent rules would eventually be introduced for the Lifetime ISA as well.

Current ISA rules do not allow for annuities to be held in an ISA, meaning that the only way the ISA can be converted into a guaranteed income for life is to move the fund into a purchased life annuity outside of the ISA regime, resulting in part of the income being taxed after all.

Obviously pension savers can already withdraw their entire fund as one lump sum in retirement, but tax tends to act as a brake on withdrawals meaning that many will stagger their withdrawals. This natural brake won’t be there on the Lifetime ISA and there is a risk that savers will run out of money more quickly.

Arguably the bigger risks are that individuals will opt out of auto-enrolment and therefore miss out on employer contributions and that individuals will withdraw large parts of their savings to purchase a first home and then have to start again on their pension savings at a later stage in life.

If an individual starts contributing £4,000 a year from age 18 to age 50, they could contribute a total of £132,000 and gain a government bonus of £33,000. Whilst this sounds like a lot, we know that many will not start saving until much later in their life and there is a question over whether £4,000 a year is really enough to provide a deposit for a first home and a decent income in retirement.

It will be 20 years from the launch in 2017 before any Lifetime ISA savers can use their funds in retirement, who knows what the pensions and ISA market will be like then?

 

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