UK Lifetime ISA (Account Options)

Lifetime ISAs are a relatively new product, and are an interesting hybrid of a “normal” ISA and a pension, kind of like a Roth IRA. Your money is locked up until age 60 except for a first home purchase, but it’s tax advantaged. The low contribution limit means this won’t be a huge part of a FIRE portfolio, but it may be useful.

It’s probably best to read the Stocks & Shares ISA article first – most of the information there applies to a Lifetime ISA as well, and I’ve tried not to be too duplicative.

Synopsis

Strong UK tax advantages plus a 25% bonus from the government, but your money is (gently) locked away and you’ll need to manage individual stocks to avoid unpleasant PFIC constraints from the US.

Priority

Definitely after UK pensions and US IRA – the tax advantages aren’t as good.

It’s a tossup between a Stocks & Shares (S&S) ISA vs a Lifetime ISA. S&S ISAs don’t give you the 25% bonus but you can withdraw your money at any time for any reason. Pick whichever is more useful to you – you could easily have both, and use the full £4,000 of the annual Lifetime ISA allowance with the remaining £16,000 of the overall £20,000 ISA allowance going to a S&S ISA.

Skip if you aren’t comfortable with individual stocks, or another way of dealing with PFIC problems.

Eligibility

All UK residents between the ages of 18 and 39 can open an account. If you’re aged 40 to 50, you can contribute to an existing account but not open a new one.

Investment Options

Same as a S&S ISA – you can hold whatever you want, but you’ll most likely want to stick to individual stocks to avoid PFIC headaches. Cash is also an option, especially if you’re using the Lifetime ISA to save for a first house in just a couple of years and don’t want that money exposed to market risk.

Risk & Return

Depends what you invest in – compared to an index fund, individual stocks are riskier, you probably want to be picking big, boring companies with relatively stable finances. But that’s no guarantee – big companies go bust, too.

You do get a guaranteed 25% return based on the bonus from the UK government. Really, all this is doing is giving you back the 20% basic rate tax rate, since you’re contributing from after-tax money. This bonus is also taxable in the US.

Withdrawal Options

Lifetime ISAs are intended for two purposes:

  • Purchase of a first home. If you’re buying a house in the UK, priced at £450,000 or less, with a mortgage, and you’ve never bought a house anywhere else in the world, you can use your Lifetime ISA for this.
  • Retirement, after age 60. No special eligibility here, just turn 60.

There are two less preferred ways of withdrawing, as well

  • Terminal illness or death. Hopefully this doesn’t happen to you, but if you do, you or your heirs can withdraw without a penalty.
  • Early withdrawal. If you withdraw for any other reason, you’ll pay a 25% penalty. This takes out the 25% bonus, plus an extra 5% (percentage math – you contribute £1,000, government gives you £250. When you withdraw £1,250, you have to pay 25%, or £312.50, leaving you with £937.50, less than you put in).
    • This isn’t a huge penalty, compared to a 401(k) or UK pension, but it’s enough to make you think twice.
    • The government has reduced the charge to 20% as a COVID measure, but this expires 05 April 2021 (it might get extended). 20% just removes the government bonus but doesn’t charge any penalty.

Contribution Limit

£4,000 limit per year, per person. This is pooled with all other ISAs, against the total £20,000 allowance. Example: you could contribute £4,000 to a Lifetime ISA and £16,000 to a S&S ISA in one year.

Fees

Similar to a S&S ISA – combination of a platform fee, dealing (aka transaction) fees, and any fees on underlying investments. These can add up fast if you trade frequently – this isn’t a great place for that, and it will also complicate your US taxes to report all those trades.

UK Tax Treatment – Contributions

Contributions are after tax, so there’s no direct tax impact. The 25% bonus from the government mimics the effect of avoiding the 20% basic tax rate – but if you’re in the 40% higher or 45% additional tax bracket, it’s only about halfway there. The bonus is also US taxable, which might further reduce the help.

UK Tax Treatment – Withdrawals

Withdrawals of both contributions and earnings are tax free, when eligible. No income tax, no capital gains tax, no tax on dividends or interest.

If you withdraw early, there’s a 25% penalty – not directly a tax, but still money you have to give to the government.

US Tax Treatment – Contributions

Contributions are after tax, so there’s no savings there, plus you need to include the 25% UK government bonus as taxable income on your US taxes. You might be able to offset it with Foreign Tax Credits on other income – you’re looking at a maximum of £1,000 a year (25% of the £4,000 annual limit).

US Tax Treatment – Withdrawals

To the IRS, a Lifetime ISA is just a taxable brokerage account. You’ll need to pay tax on capital gains, interest, dividends, etc. whenever they occur, not just on withdrawal.

This will include the distinction between short and long term capital gains, and between qualified vs ordinary dividends. Bottom line, it’s better to buy and hold, instead of trading frequently – also saves you money on dealing fees. You may also have options for tax loss harvesting.

Further Reading

MoneySavingExpert on Lifetime ISAs.

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