Why the Lifetime ISA is not a simple to understand product

I’m gonna be upfront here, this is going to be a bit of a rough and ready post. It’s incredibly one-sided. But hopefully, I’ll be coherent to persuade you of one thing: the Lifetime ISA is a complex and confusing product.

The Lifetime ISA was drawn into the firing line after the Treasury Committee recommended it’s abolition (link). Some far smarter, wiser and more experienced people have made the case that the Lifetime ISA is a complex and confusing product. Most notably, former Pensions Minister Ros Altman (link).

Arguably, the most ‘no-brainer’ case for using a LISA is for those who are funding a house purchase. But even for these people the case is not as clearly made out as you’d think. Here are some reasons why.

Inheritance

Do you have parents? Grandparents? If you inherit a share of a family home sometime in the future that will block you from using the LISA towards your house buy.

Can you plan for that? No way, well except to get yourself written out of the will.

Joint ownership

If more than one Lifetime ISA investor is jointly purchasing a residential property, then each person must satisfy the Lifetime ISA requirements. Lifetime ISA investors can purchase a property as a joint owner with a person who already owns the property, but this is also subject to the conditions of the Lifetime ISA being satisfied.

Occupation

You have to intend to live in the property as your only or main residence. How long that’s for, nobody knows. Living there part-time, no idea. Got an overseas holiday home, no clue.

Helpfully, the government never set it out any more on this in the legislation. So if you’re an NHS worker, or regularly have to move jobs, you might find yourself on the wrong end of this. I’d like to give you some certainty, but nobody appears to know if the government will whack you with a penalty if you do end up leaving the home unoccupied. I’ve searched fruitlessly. If any wise owls out there know the answer please let me know!

Buy to let

Buy to let is therefore excluded. But there is a loophole to that. If you’re a crown employee serving overseas then you don’t have to take immediate occupation. In the meantime, you can buy to let until you return. Although, it’s not precisely clear what happens if you have to live on base on your return. The guidance notes and the legislation don’t seem to quite match.

There’s a cap

The house purchase price must not exceed £450,000. Good luck with that in London or South East England.

Also, there’s no mechanism in the legislation for that limit increasing. So, you’re gonna have to rely on a future government tinkering with the legislation for any increases. Otherwise, you’ve got to there’s a future reverse in house prices.

The cap applies even for share ownership

Want to buy 25% of a £500k flat in London (i.e. £100k purchase price)? You’re not allowed, the cap applies on the whole value, not just your share. So that probably rules out the savvy people co-purchasing their first homes in London.

You have to take a mortgage

Yep, you can’t buy the home outright. You can only use the LISA for a house purchase if you fund the purchase through a loan (mortgage) or under a home purchase plan.

You can only use it against the purchase price

You can’t use it against any solicitors fees, mortgage fees, stamp duty or anything else. Only the purchase price. So you’re gonna have to still save up a fair whack in another account to be able to pay all your purchase costs. That’s still better than the disastrous help to buy ISA which blocked you from using the funds on the exchange deposit!

Got a help to buy ISA?

You can have both a help to buy ISA and a LISA. But you can only use the funds from one. However, you can transfer from a help to buy ISA into a LISA if you want.

In a chain?

Watch out – because you’ve got 90 days from when you’ve withdrawn the funds to complete. Otherwise, you’ve got to put the money back. You can ask for an extension, but there are no guarantees. Hopefully, your chain won’t break. That never happens right?

Got a caravan?

Yeah, you might not qualify. Seriously. (link)

References:

Legislation: https://www.legislation.gov.uk/ukdsi/2017/9780111154618/pdfs/ukdsi_9780111154618_en.pdf

Government’s conveyancer guidance: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/691773/conveyancer__1___5_.pdf

Gov.uk Conveyancers technical guidance: https://www.gov.uk/government/publications/conveyancers-lifetime-isa-technical-guidance/conveyancers-lifetime-isa-technical-guidance

 

p.s. I know I’m being intentionally pernickety, it’s not all as bad as I’ve made out here. But, these rules do exist. And you do need to think about them. I know lots of you readers are very financially savvy, many savvier than me! But, do I think the average 20 year-old will get all this? No chance. But they need to if they want to use a LISA to fund their future first home. And what happens when potential savers or investors are faced with unnecessary complexity – they don’t save, they don’t invest. We need products that encourage people to save. They need to simple and accessible. They need to be easy to understand and usable in financial planning.

That doesn’t mean the LISA is a bad product – in fact, the generosity of the bonus is unbeatable for many people. That’s what makes this all the more frustrating. This is a product that could help so many people. But the implementation is so poor. And we’re not just talking complexity like forecasting life-expectancy for pensions is complex. We’re talking about complicated legislation that even lawyers need guidance to understand. Good luck to the rest of us!

Happy New Tax Year!

As you’ve probably already worked out I’m a few shades different from normal. Mrs YFG has got pretty used to that over the years but one thing she still finds funny is how much I enjoy the new tax year. Every 6th of April is like a mini-Christmas to me. Now before you start calling the authorities that there is a madman on the loose – let me explain why. I’m one of those guys who likes a good deal – a bit like Harry Redknapp without the bulldog and bank accounts. And to me there seems few better deals than the annual ISA and pension giveaways that save investors 000s of pounds each year in saved income and gains taxes. Each 6th of April I’m like a squirrel, burying my nuts out of the grubby hands of the taxman.

In this post I wanted to outline what I do each new tax year and why. And then share a few comments on things that have changed this tax year. This is by no means the “warts-and-all” tax guide which I’m sure has been prepared by people much smarter and less lazy than me. But hopefully it’ll give an example of the things I think about.

What I get up to in the new tax year

Firstly, I max my ISA allowance of £20,000. Unfortunately, there was no increase to this year’s allowance, but given we got a hefty £5k increase the year before, I’m not gonna protest too much. In the past this usually involved me dumping the £20,000 I had saved up in my bank account each year. Now I’m a lazy layabout on/off worker, I only manage to save up a little bit of cash to chuck into the ISA pot. The rest of the allowance I make up using something called “Bed & ISA”. This involves selling my investments outside of a tax-wrapper and re-buying them in the ISA. Most brokers, including mine, only charge a single transaction fee (or make it completely free) to do this, making it cheaper that manually doing the transactions. When Bed & ISA-ing there are a few things to think about:

  • Defusing capital gains – by selling investments that have made some gains, I can use up your Annual Exemption of £11,700 (18/19) so that I don’t have potential CGT to pay. Once within the ISA there are no capital gains, so I won’t have to worry about this ever again. The issue is, if I sell too many assets (c.£45k) or make too many gains after losses (£11,700) I would need to file a self-assessment. You can read more about this at the excellent Monevator website.
  • Realising capital losses – on the other token, if its been a rough time for some of my investments I can sell them and claim a capital loss in a self-assessment. This can be used against future capital gains (with a few rules, check out the .gov website for all the gory details). Bear in mind that losses are used first against gains in the same year, so if I’ve also sold assets with a gain, less than the Annual Exemption, I would “lose your losses”.
  • Reducing your income tax bill – the other tax element is my income tax bill. There are two elements: (i) interest income; and (ii) dividend income. Starting with interest income, this results from the distributions of Bond funds and ETFs (to qualify, a fund/ETF must, generally speaking, hold over 60% in fixed income or cash-like assets) and from direct holdings of Gilts and Corporate Bonds (bear in mind that you don’t get charge capital gains tax on Gilts, making the need to protect them in a tax-efficient wrapper much lower). Dividend income arises from distributions from equity funds and direct share holdings. There’s also potentially different rules for REITs and you need to consider the effect of withholding tax, generally reclaimable in a SIPP but not in an ISA. All the above also applies for Reporting Funds if you have non-Reporting Funds, as defined, first give yourself a smack on the bottom and then read this, again from the great Monevator website). Interest and dividends are tax differently. Here’s the break-down:
    • Interest – you get an interest allowance of £1,000 (basic rate payers) or £500 (higher rate payers). So if your interest income from all your un-sheltered investments (remember, including bank interest) is less than these amounts you won’t have tax to pay! This can make interest paying investments less of a priority to shelter. But…
    • Dividends – In dark days gone past dividends would be paid after “deducting” a confusing notional dividend credit. In short, if you were basic rate payer you didn’t have to pay any more tax on your dividends. In 2016/17 the government finally scrapped this mind-bendingly confusing system and gave everyone a dividend allowance of £5,000, now £2,000 (see more on this below) and jacked-up the dividend rates (which are higher than for interest income). If you earn total un-sheltered dividends of less than £2,000 you don’t have tax to pay. This means that if you are likely below the allowance then sheltering dividend paying investments may be less of a priority, but if you are above the allowance then it’s more of a priority.

Back to the real world

So this tax year I’m doing the following:

  • Transferring £4,000 in cash from my savings into my stocks and shares ISA.
  • Bed & ISA-ing £16,000 of an equity ETF and re-buying it in my stocks and shares ISA. This is because this investment has a substantial gain (the total holding has a gain above the Annual Exempt amount), so by selling I’m defusing part of the gain and lowering the likelihood of having to pay CGT in the future. Secondly, I’m over the dividend allowance, so the distributions from the fund are taxable, and at a higher rate than my interest income.

As another example, I’m helping a family member do the following:

  • Bed & ISA-ing £20,000 of a bond ETF re-buying it in their stocks and shares ISA. They don’t have capital gains to worry about at the moment and they are below the dividend allowance, but above the interest allowance. So they don’t pay tax on dividends but do on interest. So moving the bond (rather than equity) investments reduces their tax.

New tax year changes for 2018/19

I wanted to close by writing about some (but not all) of the 2018/19 tax changes.

  • The Dividend Allowance – as mentioned above, this is cut from £5,000 to £2,000. Now, I’m gonna try to be calm, but this change has made me very angry. Firstly, the new allowance lasted only one year before being substantially changed. Now investors should be investing for the long-term, so when a major change to taxes is implemented (which it was, in moving from the old dividend credit system) investors are really punished when these changes last in the months not years. This is a particular bad as the allowance accompanied the pension freedoms. Many quick-thinking people may have cashed in investments from their pensions believing that they would not be stung by taxes on their investments but have easy access to them only to see the allowance slashed. I’ve also seen a number of commentators state that the case for S&S ISAs reduced because of the dividend allowance. Those not using their allowance last year might be ruing their choices. But there’s a double kicker:
  • The Money Purchase Annual Allowance (MPAA) – has been cut from £10,000 to £4,000. Broadly speaking, this is the annual amount you can put into the a pension after en-chasing a money purchase pension. So, you may have taken money out of pension, using the much touted flexibilities, thinking you won’t pay tax on your dividends and you could always put it back in to a pension at a good rate. Unfortunately, the government changed the rules drastically, again after only one year. Even worse, these changes have been enacted retrospectively from April 2017 (so anyone who hoped to stuff their pockets before the change was in legislation may come up short). I understand why these changes were made (limit pensions re-cycling and to raise tax rates on higher payers) but to investors the continually changing rules make it very difficult to plan for the long-term.
  • Auto-enrolment – From April 2018 the automatic (unless you opt-out) rate put into your pension goes up from 1% to 3% (and 1% to 2% employer contribution). There’s been a flood of articles on this in the mainstream media, but given this changes has been on the cards for years its hard to see how this is a shock. Maybe we might see more “shock” when the rate goes up to 5% (3% employer contribution) next year. Hopefully a savvy finance type you are already getting the max contribution from your employer (https://youngfiguy.com/pensions-isas-the-basics).
  • The Annual Exemption for Capital Gains nudged up from £11,300 to £11,700. The Personal Allowance also nudged up from £11,500 to £11,850, the bands for higher rate also nudged up. They didn’t for Additional Rate payers, so if you are one, please feel free to sob into your champagne…
  • The Buy-to-Let Mortgage Offset reduced from being allowed to deduct 75% of your mortgage interest on BTL income down to 50%. Apparently this is less of shock (maybe because the mainstream media went a bit mad when it was first announced). It’s going down to 25% next year, and finally to 0% in 2020/21 (just to prepare you in-case you drop your monocle in your soup when you read about it in the Telegraph next year).
  • Student Loan thresholds are going up. They are nudging up slightly for Plan 1 payers (those before 2012). More importantly, for those post 2012 (with the enormous, higher than commercial rate loans) the threshold is jumping up from £21,000 to £25,000 (as well as the interest thresholds). The threshold had been controversially ‘frozen’ at £21,000 since 2012, and by controversial I mean the Government had made a desirable retrospective money grab, breaking promises given to students. Thankfully, the thresholds are due to increase with average earnings from next year on-wards (well until the Government changes its mind again).
  • Finally, the Lifetime Allowance (LTA) is (finally) increasing from £1,000,000 to, wait for it, £1,030,000, in line with CPI (3%). No accounting for the dramatic earlier cuts or the lack of an increase last year. Finally, a little bit of good news for those who’ve done the responsible thing and built a great nest egg for retirement. Unfortunately, there’s no cast iron guarantees that the Government will keep increasing the LTA in line with inflation. So good luck forecasting 10/20/30/40 years into the future.

I hope you’ve enjoyed the post. I also sincerely hope I haven’t made any mistakes or typos – if I have please let me know! Please remember you should do your own research or speak to an authorised financial advisor or financial planner before making any and every investment decision. If you make an investment or decision on the basis of any of the information above you do it at your own risk.

All the best,

Young FI Guy

Pensions & ISAs – the basics

I was recently asked on the the excellent Monevator website what my thoughts are on pensions and saving for the future. I hope this post can give you a rough guide to how pensions and ISAs work in the UK and give you a rule of thumb about how to start using them to achieve your financial aims! I’ve included ISAs as I think you can’t understand one without the other.

 


 

When I was 16, nobody explained the concept of a pension or an ISA (or income tax, for God’s sake – yet we teach kids about Oxbow Lakes???). The second step in sensible financial planning is understanding these concepts.

Wait! What’s the first step?

Before we start on pensions and ISAs you have to understand your first step. The first step is:

Have a financial and life aim

By that, you need to ask yourself: What do I want to achieve in life? Why do I want to achieve this? Where do I have to get to financially to achieve this?

An example:

John wants to have two children with his wife and have a stable, permanent home for him and his family to live in. He wants this because he wants to give a stable upbringing to his children.

 

Without being Captain Obvious, John’s going to need a lot of money to do this. He’s going to have to save up money to put down a deposit for his house. He also has to be able to access that money. But he might not need to access any savings for a number of years. He will also need to have a stream of income when he and his wife have kids. And he will likely need to have some level of savings for one-off expenses relating to raising his children.

This also helps us address the four key factors in saving and investment. These are:

Risk tolerence, Time-horizon, access and affordability

Risk can be defined in a huge number of ways and the financial services industry has devoted sagas to what risk means. But broadly speaking, what matters is Risk tolerence – what risks are you willing to take to meet you financial aims.

Time-horizon – this is the time you have over which to meet your financial aims. Generally speaking, the longer away you are from your aim, the easier it is for you to swallow risks.

Access – this is whether you may or may not need to access your savings and investments. Generally speaking, the higher the likelihood you will need to dip into your savings pot, the lower your risk tolerence will be (to avoid making potentially large losses).

Affordability – this is whether you can actually afford to make the savings and investments you plan (i.e. what you are able to sacrifice spending today to be able to spend tomorrow). You won’t be able to afford to save everything – so you need to start prioritising how and what to save and invest.

As you can see these four concepts are interlinked.

The Second Step: Pensions and ISAs

Pensions

If you’re faced with your first “real” job, the offer of a pension may seem daunting. In the UK, the vast majority of workers over age 21 will be offered a contributory pension arrangement (where your employer pays into a pot of money which is invested until you retire). These are called Defined Contribution (DC) schemes or in old language, Money Purchase schemes. Generally you have to wait until you’re 55 to take this money – however the Government is currently thinking about increasing this age, and it has done in the past. Until then you can’t get your hands on the money and do what you want with it. At the moment you can take the entire amount in cash thanks to the now famous Pension Flexibilities (that thing the media keeps saying about pensioners spending their money on Lamborghinis). But when you take the money out, you get taxed on it.

The first question for a millennial is then : why wait till age 55? Why not just keep the money I would have otherwise put into a pension and enjoy it now? Because of three things: employer contributions, government reliefs and compound returns.

The first benefit is if your employer contributes to your pension (i.e. you pay in 5% and they match your contributions) then you’re getting free money. Literally free money. If you don’t pay in that 5% you aren’t going to get the money in lieu- it’s a quid pro quo deal. Not paying in means you’re losing out on money from your boss.

The second benefit is that the government effectively gives you back any tax you’ve paid on your salary if you put it into a pension. There are some caps on how much relief you can get, these are (in basic terms, the allowances are very complicated and the exact allowance you may have will depend on a large number of circumstances):

  • The Annual Allowance – which means you only get tax relief on the first £40,000 you put into your pension. This gets reduced down to £10,000 for very high earners by something called the Tapered Annual Allowance (which I won’t expand on for now as it’s painfully complicated).
  • The Lifetime Allowance – which means you only get to keep your relief if, when you come to take money out of your pension, the total of all your pension pots is below £1,030,000 (for 18/19). If you go above this, then HMRC will charge you a hefty penalty tax.

The Government also give another sweetener for those willing to put into a pension, that is when you take out the money you usually get to take 25% of it tax-free!

The third benefit is that as your money is left in a pension for a very long time you start to get “compound returns”. That is, returns on returns. Over 20/30/40/50 years, the compounding effect can become enormous. This is sometimes called a “snowball effect” – as a snowball rolls down a snowy mountain side it picks up more and more snow and gets rapidly bigger. A pension’s biggest weakness – that your money is trapped for a long time – is also its biggest strength. By not being able to touch your money you can’t prevent your snowball from becoming an avalanche.

As a second option, there are Personal Pension Plans (called PPPs) and SIPPs (Self-invested pension plans). These work much like a workplace scheme, except you put money in from your after tax-earnings. HMRC then automatically add 20% to whatever you put in (you have to claim the extra 20% if you are a higher rate tax payer via self-assessment or by application). You then select your investment option from a list of available investments – which are typically much broader than for workplace pensions, particularly so for SIPPs.

But there is a big problem with pensions. That is, because your money is locked in, you are at the mercy of the rules the government comes up with. You would think that, as the government wants people to save, it would try to keep the rules as consistent and as simple as possible. Unfortunately, that is not the case. Politicians have continually meddled with pensions and its clear they will continue to do so. When I speak to people, my general guidance on this is:

Think up your rough retirement date. Say its 20 years away. Between now and then there will be at least 4 governments. Now imagine the worst possible government (for your financial aims) that you could get during that time (or Donald Trump…). If you put your money into a pension, you are completely at the whim of that government. Could you live with that arrangement?

 

Usually this scares people a bit. And at this point it is should be clear pensions can’t be the only answer. That’s where ISAs come in.

 

ISAs

An ISA (Individual Savings Account) can either be a cash ISA (an account which earns interest at a set rate) or a stocks and shares ISA (you put your money into pooled investments linked to the market). You can only invest a certain amount into any ISA/s in one year – capped at £20,000 in 18/19. The earlier you open an ISA the longer you have to build up your snowball. You can also take your money in and out whenever you want subject to the cap – however, most places now offer “Flexi-ISAs” which allow you to take money out and put it back in and not lose part of your allowance. With an ISA you don’t get tax relief on money you put in. But, money you make in an ISA is tax-free – both income and gains. In effect, its like a ghost to HMRC.

HMRC don’t like ghosts and so George Osborne came up with a bastard-child of ISAs and pensions called a Lifetime ISA or a LISA (primarily because the treasury gets to hold on to tax money for longer if you put it in a LISA). You can only put £4,000 a year into a LISA (and that counts as part of the £20,000 above). But the government gives you a generous 25% bonus on the money you put in i.e. for every £100 you put in the government gives you £25. In addition you won’t be taxed when you are able to take money out of a LISA. But the government aren’t (always) in the business of giving out free money. There’s a catch – and it’s a big one. You can’t touch the money until you are either 60 (yes, that’s older than for other pensions) or to buy your first home (and in true government fashion, there is a huge small print on what homes can actually count, so you have to be very careful if this is what you are planning). Strictly speaking you can take your money out of a LISA, but there is a huge penalty for doing so and it would be extremely inadvisable to do so. One final catch is if you are over 40, you can’t open one. Sorry – you’re out of luck.

With all that out of the way, let me present the YoungFIGuy Pension and ISA Super Table! (it’s not that super, don’t get your hopes up). Please note, and I have to say this, I’m not an FCA authorised financial adviser. The table below is a rough guide/rule of thumb for information purposes only and should not be considered financial advice. The table may contain incorrect information or mistakes. You should do your own research or speak to an authorised financial advisor or financial planner before making any and every investment decision. If you make an investment or decision on the basis of any information you do it at your own risk.

I have spare money and want to save and invest for my future what do I do? Note: this is rough guide – what is best for you will depend on your exact circumstances – I would always recommend seeking the advice of a personal finance professional
      Pros Cons
1 If you are employed, contribute to your workplace pension up to the amount that maxes the free money from your employer If you are not an employee go to 2 – FREE MONEY

– Generous tax reliefs

– You can’t meddle by taking money out

– Your money will be tied up until at least 55 – check access requirements

– The pension investment options can be expensive

– There are usually limited investment options

2 If you do not own or have never owned your own home and you plan to do so, max out your LISA.

(Subject to the type of home you are buying qualifying for the scheme)

If you own or owned a home, or the home you’d like doesn’t qualify go to 3 – Very Generous tax relief

– You’ll get access to your money before any pension

– Lots of investment options: from low risk to high risk

– Some homes and some situations mean you won’t qualify to withdraw to buy a home, then you can’t withdraw until at least 60 – check access requirements

– You are at risk the government changes the rules on you

– Not as widely available as pensions and ISAs

3 Max out the rest of your ISA allowance   – All income and gains are tax-free

– You can access your money whenever you want (and put it back in with a Flexi-ISA)

– Lots of investment options: from low risk to high risk

– The total tax relief is not as good as for a LISA or a pension

– You are in control, you have to have the discipline to not take money out on a whim

4 If your company offers “salary sacrifice” and they give you any national insurance savings they make by paying money straight into your pension, then contribute as much up to the Annual Allowance (AA) If your employer doesn’t offer salary sacrifice got to 5, if you’ve maxed your AA go to 7 – You get an added bonus from saving NI contributions

– Generous tax reliefs

– You can’t meddle by taking money out

As under 1
5 If the annual costs for investments in the company pension scheme are less than 0.5% then contribute as much up to the Annual Allowance If the costs are above 0.5% you can generally speaking invest for less in a private pension or SIPP – Generous tax reliefs

– You can’t meddle by taking money out

As under 1
6 Invest into a private pension or a SIPP up to the Annual Allowance if you’ve maxed your AA go to 7 – Generous tax reliefs

– You can’t meddle by taking money out

– Lots of investment options: from low risk to high risk

– Your money will be tied up until at least 55 – check access requirements

– The pension investment options can be expensive

7 Well done, you’ve saved a bollock-ton of money! At this point there are a number of tax-efficient and non-tax-efficient options available, you should speak to an Independent Financial Advisor about which ones might work best for you

 

If you have any thoughts, suggestions or questions, please feel free to leave a comment!

All the best,

YFG