Concerns Over Lifetime Isa Penalties Reach Critical Level

Calls for reforms to the Lifetime Isa are intensifying ahead of next month’s budget, aimed at preventing significant financial losses for numerous savers.

HM Revenue & Customs has reported that over £75 million in penalties were incurred by savers making withdrawals from Lifetime Isas throughout the 2023-24 tax year.

Specifically designed for aiding individuals in saving for their first home or retirement, Lifetime Isas can be initiated by adults under 40. Each tax year, savers can deposit up to £4,000 until they reach the age of 50, receiving a government bonus of 25%. If a person consistently saved the maximum of £4,000 from age 18 onwards, they could potentially accrue a government bonus totaling £32,000.

However, a substantial caveat exists: any withdrawal not intended for purchasing a first home or made after the age of 60 incurs a 25% penalty. This system results in a loss of both the government bonus and significant portions of one’s personal savings.

Advocates for change argue that the current constraints are overly restrictive, and urge an overhaul to the rules to prevent unfair penalties on individuals who require access to their funds in emergencies.

Understanding Lifetime Isas

Since their introduction in 2017, Lifetime Isas have gained traction, replacing the Help to Buy Isa. In the 2022-23 tax year, savers deposited £2.4 billion into 767,000 accounts, an increase from the previous year’s £1.7 billion across 662,000 accounts. To date, the scheme has facilitated the purchase of 227,600 homes, with total bonuses of £1.99 billion distributed to savers.

Nonetheless, there has been a notable rise in the number of savers facing penalties for ‘unauthorised withdrawals’, which occur when funds are withdrawn for purposes outside of home purchasing or retirement. In the 2023-24 period, 99,650 individuals incurred £75.3 million in penalties for such withdrawals, up from 76,000 who faced £54.3 million the previous year. The average withdrawal in this category was £3,022 in 2023-24, compared to £2,859 the year before.

This 25% penalty means that savers are losing not only the government’s bonus but also a portion of their saved money. For instance, if a saver deposits £4,000 in a year, earning a £1,000 bonus for a total of £5,000, accessing that money for something like a vehicle purchase would incur a £1,250 penalty, leaving them with merely £3,750 – less than their initial savings.

Rachael Griffin from Quilter wealth management expressed, «The penalty is significantly unfair, as it diminishes the savings individuals have diligently accumulated.»

Advocating for Penalty Reduction

Campaigners are directing their appeals towards Chancellor Rachel Reeves, requesting a reduction in the penalty during the upcoming budget announcement on October 31.

Laura Suter from AJ Bell remarked, «The 25% early withdrawal fee essentially functions as a 6.25% exit penalty. It unjustly penalizes those facing unexpected circumstances that hinder their homeownership goals.»

A hypothetical scenario where the penalty was decreased to 20% would mean savers only lose the bonus, preserving their principal investment. Therefore, in the previous example, a saver would lose £1,000, leaving their initial £4,000 intact.

Although there was a temporary reduction of the penalty to 20% during March 2020 to aid savers during the pandemic, this rate reverted to 25% in April 2021.

Griffin emphasized, «Given the current economic climate, many individuals are withdrawing funds for daily living expenses or occasional luxuries. Therefore, mitigating the penalty is an essential modification needed for the Lifetime Isa.»

The government has reiterated that the penalty serves to maintain the integrity of the Lifetime Isa as a long-term savings vehicle.

Restrictions on Property Purchase

Furthermore, savers can face additional penalties if the property they wish to purchase exceeds the value set by the Lifetime Isa, which is currently capped at £450,000. This limit hasn’t been adjusted since the product was launched in 2017, when the average property price in England stood at £235,021. Currently, the average property price has surged by 30% to £305,879, reaching £520,747 in London.

If the cap had been updated to reflect the rise in property prices, it would have been set at approximately £585,000 today, still permitting the purchase of an average London home without penalties under the Lifetime Isa.

Helen Morrissey of Hargreaves Lansdown stated, «First-time buyers in high-value postcode areas are increasingly unable to find suitable homes within this price limit unless adjustments are made soon.»

Limitations on Age

Critics are also highlighting that the age restrictions related to Lifetime Isas are excessively confining. Individuals who are 40 years or older cannot open an account, and contributions cease at age 50, despite the product being partially aimed at bolstering retirement savings.

This limitation could deter self-employed individuals, who lack the automatic advantages of company pensions, from utilizing a Lifetime Isa as part of their retirement strategy.

Due to the 25% government bonus being comparable to the tax relief available for basic rate tax-payers on pension contributions, Lifetime Isas have been promoted as an alternative to self-invested personal pensions (Sipps).

However, many self-employed individuals hesitate to establish pension plans, which typically lock funds until age 55, progressively rising to 57 by 2028. They prefer flexible savings accounts readily available for urgent business needs, yet the Lifetime Isa presents similar limitations.

Adjusting the withdrawal age limit or extending the duration for opening an account could incentivize more individuals to prepare for retirement, advocates argue.

Government statistics indicate that there are approximately 4.3 million self-employed individuals in the UK, encompassing about 2.1 million aged 50 and above, who are thus unable to contribute to a Lifetime Isa.

Andrew Chamberlain from the Association of Independent Professionals and the Self-Employed opined, «If age limits are maintained for new accounts, they should be raised to 55, affording mid-career professionals enhanced saving options as they transition to freelance work.»

A Treasury spokesperson addressed concerns by stating that despite rising first-time home prices, it remains beneath the £450,000 Lifetime Isa threshold in most regions.

A Personal Situation: Concerns of Losing Savings

Archie Marshall, a 21-year-old civil servant from the East Midlands, faces a 39-year wait to access his Lifetime Isa savings – unless he accepts a substantial penalty.

Marshall established his stocks and shares Lifetime Isa with AJ Bell in 2021, consistently saving the maximum £4,000 annually.

Unlike many young adults, Marshall plans to utilize his Lifetime Isa for retirement savings, as he has already secured a home through a Help to Buy Isa, which was phased out in November 2019. Only one government bonus from either account can be used for the purchase of a first home.

In April 2022, Marshall purchased a two-bedroom house valued at £207,000, utilizing £10,500 from his Help to Buy Isa, which provided a government bonus of £2,625. However, this decision means he cannot access the Lifetime Isa until he turns 60, facing a 25% penalty for earlier withdrawals.

Determined to maximize his contributions, Marshall aims to accumulate £32,000 through the Lifetime Isa bonus. Yet, he recently realized that accessing his funds early would mean losing both his bonus and part of his savings.

Marshall expressed his frustration, stating, «I initially believed that dipping into my savings wouldn’t result in losing my initial amount, but now I realize I must be significantly more cautious.»

«It would be beneficial for the government to lower the penalty from 25% to 20%, allowing individuals to access their funds in emergencies without depleting their original savings. Otherwise, I may never utilize my account.»