How to find the best lifetime ISA

Individual savings accounts (ISAs) are government-backed financial products offering tax-free ways to save and invest.

The ISA family comprises several versions of the product, each aimed at different types of saver and investor. Lifetime ISAs, for example, were launched five years ago to give people in a certain age range the chance to save for their first home or make plans for their retirement.

Here’s an explanation of what lifetime ISAs are, how they work and what you need to know about picking one that best suits your needs.

What is an ISA?

The main thing to remember about ISAs is that they are a type of financial wrapper offering a tax-free way to save and invest.

Saving and investing tax-free are good things to do. The less tax you’re legally obliged to pay on your savings and investments, the more money you get to keep.

Every adult in the UK is given an annual ISA allowance which currently stands at £20,000 for the current 2021/22 tax year. This is the maximum amount you’re allowed to save into your ISA pot for the tax year that started on 6 April 2021 and ends this year on 5 April.

ISAs come in different guises. Many savers, for example, prefer the security of keeping their money in so-called ‘cash ISAs’ – effectively tax-free savings accounts that you can take out from the age of 16.

In contrast, you have to be at least 18 to take out a stocks and shares ISA, a different sort of arrangement that provides more adventurous investors the chance to gain exposure to the stock market.

What is a lifetime ISA?

The lifetime ISA is different to both its cash and stocks and shares siblings. It’s only available to certain age groups and was created by the government with two specific purposes in mind.

In essence, the lifetime ISA is a government-backed savings scheme that was created to allow people over the age of 18, but under the age of 40 to save, tax free, for their first home or to help supplement their retirement earnings from the age of 60 onwards.

These two different purposes, home buying and retirement, are explained below.

How do I open a lifetime ISA?

You need to be either a UK resident, or a Crown servant to take one out. In the case of a Crown servant, this might be if you’re a member of the armed forces who is serving overseas.

If you relocate abroad, but don’t qualify as a Crown servant, you have to stop making contributions to a lifetime ISA that you’ve already taken out.

Lifetime ISAs are offered by a number of banks, building societies and other providers including certain online investment platforms and apps.

What are the benefits?

A major element of the lifetime ISA’s appeal is that it provides your money with a significant boost because the government adds to your savings.

That said, lifetime ISAs come with strict rules that can potentially cause account holders to trip up financially. Read more about these and how to avoid being caught out below.

Despite their conditions, lifetime ISAs have, since their introduction, proved increasingly popular with the UK investing public.

HM Revenue & Customs says 154,000 people paid into a lifetime ISA during the tax year 2017-18. But this figure rose by around half to 223,000 in 2018-19. The number then more than doubled again to 545,000 in the tax year 2019-20 with savers stashing away £1.26 billion, an average of £2,303.

Two types of lifetime ISA

Broadly speaking, lifetime ISAs come in two versions. Both types can usually be opened online, or via an app.

The first is the cash lifetime ISA that pays interest in a similar way to a deposit account. Table 1 provides a list of lifetime ISA providers.

Table 1: Cash lifetime ISAs

Note: *Homebuyer lifetime ISA ** Reduces to 0.25% after 1 year ***From existing lifetime ISAs

Stocks and shares lifetime ISAs, on the other hand, offer investors exposure to the stock market. See Tables 2 and 3 below.

Over time, stocks and shares lifetime ISAs have the potential to produce superior returns to their cash-based relatives. But stock market investments come with no guarantees, making them a riskier proposition with the potential for investors to lose their cash.

Table 2: Stocks and shares lifetime ISA providers

Note: The Share Centre Lifetime ISA has moved to OneFamily; Transact runs a lifetime ISA via financial advisers

Table 3: Stocks and shares lifetime ISA – fees

How do lifetime ISAs work?

If you’re aged between 18 and 39 you can open a lifetime ISA and save up to £4,000 tax-free each year, up to and including the day before your 50^th birthday. This amount makes up part of your annual £20,000 ISA allowance.

The government then agrees to pay a 25% bonus on top of your lifetime ISA contributions, up to a ceiling of £1,000 a year. If you contribute your full allowance each year between the ages of 18 and 49, you can earn a bonus worth £33,000 from the state.

This bonus is paid every year you save money into your lifetime ISA, until you reach the age of 50.

At this point, you’re not allowed to make any further payments into the account or receive the bonus. But the plan stays open till you reach the age of 60 when you’re allowed to access the funds, penalty-free.

Access - at a price

If you need access to your money for a reason other than buying a home, but are unable to wait until you reach 60, you can do so – but there’s a catch. See below.

The bonus is paid monthly, if you’ve contributed in a particular month, and should be credited to your lifetime ISA within one or two months. The bonus is only paid on the contributions made, not any interest or investment growth that’s been generated.

But once the bonus is in your account, it will count alongside the rest of your money and, depending on which sort of lifetime ISA you’ve taken out, attract either interest or investment growth (or losses, should your holdings have fallen from their original value).

Lifetime ISA to buy a property

Part of the thinking behind the lifetime ISA is to help would-be homeowners get on to the housing ladder.

The rules say you need to be a first-time buyer (that is, never have owned bricks and mortar before) if you’re using a lifetime ISA to help save for a deposit on a property.

Note that if you’ve inherited a property at some point but never lived in it – and sold it immediately – that would still count as having owned a property.

Before you can withdraw the cash and use it for a deposit, the rules say your lifetime ISA should have been up and running for a year. After that, you can withdraw your deposit money at any point – there is no need to maintain the plan until you are 40.

Would-be landlords beware

What the lifetime ISA is not supposed to do is help would-be property buyers buy a home that they intend to rent out immediately after getting their hands on the keys.

Importantly, potential homebuyers should bear in mind that the cash built up in a lifetime ISA can only be used to help buy a property valued up to a certain amount.

The cap is up to £450,000 with the London area, while the ceiling reduces to £250,000 for anywhere else in the UK. Neither limit has been raised since lifetime ISAs were first introduced in 2017, even though average house prices have risen by more than 20% over this period.

What’s the catch?

If the property you want to buy is worth more than the permitted level, you can still withdraw the cash, but you pay a hefty financial penalty for doing so – an eye-watering 25% of the amount you intend to withdraw.

This is vitally important to bear in mind, because breaking the rules on limits, even accidentally, could leave you substantially out of pocket.

A Freedom of Information request by the investment platform Hargreaves Lansdown found that the government received £34 million in lifetime ISA penalties for the 2020-21 tax year alone.

You can use the lifetime ISA in combination with other government-backed property schemes such as ‘Right to Buy’ and shared ownership.

Where you’re putting the proceeds from your lifetime ISA towards buying a property, note that the due moment, the money is transferred directly from your provider to your conveyancer or solicitor, not to you.

Property purchases are usually expected to be made within 90 days of the money leaving your account. If there’s a delay, you’d need to contact HM Revenue & Customs to explain that there’s a been a hold-up.

Lifetime ISA for retirement saving

The oldest age you’re allowed to be when setting up a lifetime ISA is 39. If you’re not planning on using the scheme for homebuying purposes but are thinking of boosting your retirement funds instead, remember that you’ll have to wait more than 20 years to access your cash, penalty-free.

Once you reach 60, however, you can use the money as you like. You receive the cash tax-free and it need not be taken all in one go as gradual withdrawals are permitted. Money remaining in your account continues to attract interest or investment gains (or losses).

Although such considerations may be a long way off, it’s worth remembering that lifetime ISA savings will be counted should you potentially be eligible for benefits that require means-testing.

How do I choose a lifetime ISA?

If your preference is for a cash lifetime ISA, it’s worth remembering that not all providers pay the same amount of interest. Rates are subject to change, so it’s worth shopping around.

When it comes to the fees charged by providers of stocks and shares ISAs, these are more complicated to unpick because investment options vary from one product to another.

Not only do prices reflect an ISA provider’s own administration charges, there are often additional fees applied by the fund managers who actually invest your money in the stock market.

A complicated patchwork of admin fees can include annual portfolio charges, dealing charges (for both buying and selling investments), plus transfer fees should you decide to move your holdings to a rival provider.

Before deciding on a provider, work out what sort of investor you’re going to be to try and avoid unnecessary charges. For example, if you intend to buy and sell holdings frequently, it’s worth avoiding providers that charge you every time you want to carry out a trade.

Opening an account

Once you’ve chosen a lifetime ISA provider, the easiest way to start an account is either online or via an app.

You’ll need to confirm you’re a UK citizen and provide your name, date of birth, address and other contact information, along with your National Insurance number.

You can only open one lifetime ISA per year. If you end up with several accounts on the go, you’re limited to paying contributions into just one version each time.

Most lifetime ISA providers accept transfers of money from existing ISA accounts you might already hold elsewhere. Should you decide to move your funds from one provider to a rival, you may be charged an exit fee.