A Lifetime ISA is a flexible, affordable way for young people to save for their first home, or for an income in later life. You can open one if you’re between 18 and 39 years old.

In this article we will look at the main features of a Lifetime ISA and illustrate using a hypothetical scenario how the vehicle could get you on the property ladder sooner than you might think.

HOW IT WORKS

You can choose to save your money in cash or to invest in the stock market, and as with other ISAs your money can grow free from UK tax.

However, the big attraction of the Lifetime ISA is that the government pays a 25% ‘bonus’ on whatever you pay in up to a value of £1,000 a year.

You can save up to £4,000 each tax year. If you pay in £1,000 a year, the government will pay a bonus of £250 on top.

If you pay in the maximum £4,000, the government will top it up with the maximum bonus of £1,000. You can do this every year until you’re 50.

Someone who puts the maximum £4,000 into a Lifetime ISA every year from the age of 18 until they are 50 will get a total bonus of £32,000 from the government in annual payments, before any interest or growth.

Someone who puts in £4,000 per year from the age of 39 until they are 50 will still get a bonus from the government of £11,000.

The maximum of £4,000 each tax year forms part of the overall £20,000 ISA annual allowance, so if you put in the full £4,000 you can still put up to £16,000 in other ISAs.

It’s worth reiterating that any growth is free from UK tax, although tax rules can change and their benefits depend on your circumstances.

HOW YOU CAN USE IT TO BUY A PROPERTY

One of the main uses of a Lifetime ISA is to help you build up enough money to put down a deposit on a flat or a house later in life.

If you aren’t buying a property you can only access your Lifetime ISA if you are aged 60 or over, or you are terminally ill with less than 12 months to live.

If you take money out for any other reason before you are 60, you face a 25% penalty. However, in recognition of the fact that many people may need to access their savings early due to the coronavirus crisis, the government has reduced the penalty to 20% until 5 April 2021.

INVESTMENT OPTIONS

If you’re saving for a deposit, are in your mid-30s say, and you don’t like taking risks, you could opt to keep your ISA allowance in cash rather than stocks or funds as markets can be volatile in the short term. Certainly if you have a time horizon of five years or less there is a strong case for parking your money in a savings account.

However, if you have longer to play with and are able to ride out the market’s ups and downs, you should consider investing in one of the handful of ‘superior funds’ which have chalked up consistently above-average returns over the long term.

In the Investment Association’s UK All Companies sector, just three funds have managed to deliver top-quartile performance over one, three, five and 10 years: Baillie Gifford UK Equity Alpha (0585819), Royal London Sustainable Leaders Trust (B7V23Z9) and TB Saracen UK Alpha (0571119).

Given that the UK market has lagged its international peers for several years due to political concerns and fears over Brexit, all of which are now in the rear-view mirror, investors expect UK stocks to do well in coming years as they narrow the valuation discount with overseas markets.

Fundsmith Equity

BUY at 547.26p 

However, if you want exposure to global markets, we would recommend Fundsmith Equity (B41YBW7) which invests in a rigorously-selected portfolio of high-quality companies with high returns on capital.

Over five years and 10 years the £21 billion fund has returned an average annualized 18%, but it has had a modest start to 2021 with a return of -2% according to Morningstar, making this an ideal opportunity to start buying.

Martin Currie Global Portfolio Trust 

BUY at 375.8p

In the investment trust sector we would recommend the Martin Currie Global Portfolio Trust (MNP), which has generated an average 14% annual return over the last ten years and a 19% annual return over the last five years.

HSBC MSCI World ETF

BUY at £19.84

One of the simplest and cheapest options for someone looking to get very broad exposure to equities is to buy an exchange-traded fund that tracks the MSCI World index. This could be an ideal investment for a Lifetime ISA as long as you’ve got at least three years to invest and ride the ups and downs of the stock market.

The MSCI World index is a basket of approximately 1,500 large and medium-sized companies listed on markets in 23 developed market countries. You’ll get exposure to household names such as Apple, Microsoft and Amazon as well as some less-familiar companies that are still big names in their respective industries.

HSBC MSCI World ETF GBP (HMWO) tracks this index and only charges 0.15% a year, which is considerably cheaper than most actively managed funds. It has achieved 11.3% annualised returns over the past 10 years, according to Morningstar.

How it works in practice

We’ll use two examples to show how to make the most out of your Lifetime ISA allowance.

Let’s assume you’re 26, you live in Manchester, and the average deposit is £28,000 or 17% of the value of a house. If you put £200 a month into a standard savings account, it will take you almost 12 years to build up enough savings to cover the deposit given the low interest rates on offer.

If you save £200 a month in a Lifetime ISA, on the other hand, the government will top up your contribution by a quarter or £50 per month. Without factoring in any interest income, using the ISA you can cover the deposit in just over nine years, which is a big difference.

Putting £200 in a savings account every month:

£200 x 12 = £2,400 a year

£28,000 / £2,400 = 11 years and eight months

Putting £200 in a Lifetime ISA every month:

£250 x 12 = £3,000 a year

£28,000 / £3,000 = nine years and three months

Source: Shares

Note we haven’t assumed any income or change in contributions. Either or both of those would reduce the time it takes to build up enough for a deposit.

Say you were to earn a 5% annual return on your contributions, paid at the end of each year, then your £250 a month – which includes the government’s 25% or £50 ‘bonus’ – would get you a £28,000 deposit in less than eight years.

By the power of compounding, after seven years your Lifetime ISA would be worth more than £25,500.

If you’re lucky enough to be able to save £4,000 a year or £333 a month, and you live in Bristol, say, where the average deposit is £45,000, again it makes a great deal of sense to use a Lifetime ISA.

Putting £333 in a savings account  every month:

£333 x 12 = £4,000 a year

£45,000 / £4,000 = 11 years and three months

Putting £333 in a Lifetime ISA every month:

£416 x 12 = £5,000 a year

£45,000 / £5,000 = nine years

Source: Shares

If we do the same exercise and add compound interest at a rate of 5% per year the acceleration is equally impressive. By the end of the seventh year your ISA would be worth £42,745.

Though remember even with a time horizon of between five or 10 years you might need to consider moving some of your portfolio to lower risk assets as you got closer to the point of needing to use your deposit. Otherwise you could see a bout of market volatility wipe out your gains.

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