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Lifetime ISAs

Individual Savings Accounts (ISAs) are tax-free savings and investment accounts. There are four kinds of ISAs available to UK adults: cash, stocks and shares, innovative finance, and Lifetime ISAs. Individuals have an ISA allowance which is the maximum amount of money they can put into all of their ISA accounts combined in a single tax year; as of 2020-21 the ISA allowance is £20,000 [1].

ISAs are almost completely tax-free. ISA holders do not pay tax on interest from cash savings or on any income, dividends, or capital gains made from investments held in ISA [2]. The only tax liability that might arise from an ISA is that they do count as part of an individual’s estate for Inheritance Tax purposes [3].

Cash and stocks and shares ISAs are straightforward: the former holds cash savings; the latter can be used to hold investments such as shares, investment funds, and corporate or government bonds. Innovative finance ISAs can be used to make non-traditional investments such as peer-to-peer loans and “crowdfunding debentures”.

Lifetime ISAs are a special kind of ISA which are meant to be used by people saving up for a home or for retirement. They can only be opened by people aged 18-40 and contributions can only be made up to the age of 50. The maximum amount that can be contributed to a Lifetime ISA each year is £4,000 – this does still count towards the overall ISA allowance – and this can be held in the form of cash and/or stocks and shares. As well as any gains from holdings being tax-free like any other ISA, the government will top up Lifetime ISA contributions by 25%, so if a holder were to put in the maximum £4,000 the government would add an additional £1,000. Withdrawals from a Lifetime ISA are only authorised for the purpose of buying the holder’s first home, if the holder is aged 60+, or if the holder is terminally ill with less than 12 months to live. “Unauthorised” withdrawals for any other reason carry a 25% charge, effectively forfeiting the government bonus [4].

Children can also save money in Junior ISAs which can hold cash and/or stocks and shares. The annual limit for contributions to a Junior ISA is £9,000 and money cannot be withdrawn until the account holder turns 18 [5].

Compound tax reliefs.

The fact that once cash or investments are put into an ISA they are untouched by tax forever (save for Inheritance Tax) allows people who can afford to save a substantial portion of their money the opportunity to build up very large pots of tax-free savings. Any returns on their savings, be it interest, dividends or capital gains, will further increase the size of their ISA holdings without adding any tax liability. An individual who puts maxes out their ISA allowance each year can put hundreds of thousands of pounds into ISAs over the course of their working life and any decent rate of return will cause that fortune to grow exponentially. Families who coordinate their savings can create even greater savings: a couple can put a combined total of £40,000/year into their individual ISAs and they can add an extra £9,000/year per child in Junior ISAs.

Lifetime ISAs are even more generous. Someone who makes the maximum contribution into a Lifetime ISA for every year they are eligible will have put in £128,000 by the time they reach 50 and received an extra £32,000 just from the government top-ups in addition to any returns their savings and investments have generated.

Maximising their use of ISA allowances and making good investments within ISAs has allowed several hundred people to become ISA millionaires, accumulating seven-figure fortunes that they can enjoy without having to pay any tax on their gains. Given that ISAs have only existed for 21 years and in previous years had much lower annual allowances – originally just £7,000 and only raised to over £10,000 in 2010, reaching its current level in 2017 [6] – it is practically certain that the number of ISA millionaires will increase, probably quite rapidly, as more people who have held ISAs for longer and been able to contribute for longer join the club [7].

Changing rationale

“The Isa was designed to broaden the opportunities to save and widen the numbers of people on middle and lower incomes who were saving for their future.”

– Gordon Brown, former Chancellor of the Exchequer [8]

ISAs were introduced in 1999 with the intention of simplifying the range of tax-advantaged savings opportunities and making them more attractive to people on relatively low incomes. Replacing Personal Equity Plans and Tax-Exempt Special Savings Accounts, ISAs offered greater tax relief and allowed for withdrawals at any time, a deliberate move to encourage people on low and variable incomes who were reluctant to commit money to locked-in long-term savings accounts to save in ISAs which they could freely access. As mentioned above, ISAs originally had comparatively modest limits: a £7,000/year allowance which was intended to be reduced to £5,000 after the first few years, though that reduction never actually took place [9]. Successive reforms ensured that ISAs would instead be progressively expanded to the very generous level they are at today.

The function of ISAs has also been expanded from easy-access tax-free savings accounts to products designed to encourage long-term savings for milestone events. Help to Buy ISAs were introduced in 2015 to make it easier for first-time buyers to save up for a deposit [10] (instead of taking action to bring soaring house prices under control) and were later folded into Lifetime ISAs which are intended for people saving for buying a home or for retirement. These products directly contradict the original purpose of ISAs offering easy access to savings, instead imposing restrictions on what withdrawals can be made for. This had led to Lifetime ISAs being criticised by MPs on the basis that there has been limited take-up and no evidence that they encourage vulnerable households to save [11].

The distribution of ISA holdings.

ISAs have been successful at encouraging low- and middle-income households to save to the extent that their use is widespread across the income distribution. The most recent official statistics show there are 22 million adult ISA holders with the vast majority being people on low to average incomes, the median ISA holder having an annual income of £10,000-£19,999 and the average annual contribution is just over £6,000. However, the size of contributions and holdings varies greatly across the income distribution. The majority of low-income ISA holders make small contributions of less than £2,500/year and have a fairly modest savings pot; those in £10,000-£19,999 income bracket have average ISA savings of about £24,000. People on high incomes make more use of the maximum allowance, with the majority of ISA holders with incomes of over £150,000 contributing the maximum £20,000; the average ISA holdings of this highest income bracket is more than £80,000 [12]. It is clear that while ISAs are a very popular product, it is the richest holders who are able to maximise their holdings and enjoy the greatest tax reliefs.

A 2011 report by the IPPR already argued that ISAs were failing to achieve their originally stated objectives, with many low- to middle-income households still having inadequate savings while most of the tax relief on ISAs was being claimed by people who would have saved anyway and therefore did not need the incentive [13]. More recent statistics show that 41% of people don’t have enough savings to live for a month without an income, with about one-third having less than £600 saved up and one-tenth having no savings whatsoever [14].Tax relief on ISAs costs the government more than £3 billion/year in foregone tax revenue [15] and the benefits are disproportionately accrued by relatively well-off households who don’t need the support.

ISA holdings can even pose a problem for poor and vulnerable households if they find themselves in a position of needing to claim social security benefits. Universal Credit rules place limits on the support individuals can get if they have significant savings; the benefit is reduced if a claimant has more than £6,000 in savings and denied entirely to people who have more than £16,000 saved up. While ISAs don’t count towards taxable liabilities, they do count as savings for this purpose and so while the government is trying to encourage people to put money aside for a deposit or their retirement with one hand, they are requiring them to run down their savings should they encounter economic difficulties with the other [16].

ISAs also exacerbate the general feature of the UK tax system that wealth is treated much more kindly than work. Savings and investments are already taxed lightly. Basic rate taxpayers can receive up to £1,000 in interest tax-free, falling to £500 for Higher rate taxpayers and zero for Additional rate taxpayers [17]. Given how low interest rates are, currently less than 1% on typical savings accounts, such that an individual would need to have tens of thousands of pounds in savings to exceed those interest limits, this effectively excludes the vast majority of people from paying any tax on interest whether or not their savings are in an ISA. Individuals can also make £2,000/year from dividends [18] and £12,300/year in capital gain [19] before being taxed; even if someone does exceed those limits they are taxed at lower rates, with Dividend Tax being slightly lower than Income Tax and Capital Gains Tax for stocks and shares being half of Income Tax rates. To sum up, even if ISAs did not exist it is largely only wealthy households with especially large accumulations of savings and investments who would find themselves being taxed, so the primary effect of ISAs is to allow those people to have even more tax-free holdings. ISAs, intended to encourage and reward savers with modest incomes, instead function largely as a subsidy to the wealthy.

Reform or abolish ISAs?

It should be clear that ISAs are excessively generous but given their widespread usage outright abolition may be politically infeasible as it could be perceived as an attack on people who use their ISAs to manage relatively small amounts of money. A simple reform which would lessen the contribution ISAs make to wealth inequality would be to just make them a bit less generous. For example, halving the annual ISA allowance to £10,000 would greatly reduce the amount high-income households could put in while leaving low-income savers largely unaffected; similarly introducing a lifetime limit on contributions in additional to the annual allowance would prevent ISAs being used to accumulate six- or even seven-figure tax-free fortunes and restoring their original purpose. The accountant Richard Murphy of Tax Justice UK has proposed a lifetime limit of £100,000 [20]; given that this is greater than even the average ISA holdings of individuals with incomes over £150,000 the limit could plausibly be much lower without seriously impacting anyone but the richest households.

Bolder reforms could be undertaken to seriously address the imbalance in the tax system between income from wealth and from work while still providing some support for low-income savers. One benefit of ISAs is they offer a simple and clear route for savings. While most ISA holders would probably not have to pay any tax on interest, dividends or capital gains on savings held outside ISAs thanks to the array of tax-free allowances, that range of allowances is more complicated to understand and take advantage of than the obvious attraction of an account that is explicitly tax-free. It may be worth consolidating the various tax-free allowances, allowing individuals to make a certain amount in combined returns from savings and investments before tax each year and integrating that into the ISA system. There is no need to have both tax-free savings accounts and various tax-free allowances outside those accounts, so either ISA allowances should be the only tax relief for savings with the other allowances abolished, or there should be a general allowance with ISAs being just one way to make use of it. An even bolder reform would be to merge savings allowances with the Personal Allowance for Income Tax, giving individuals a single tax-free allowance on income from all sources with tax paid on everything in excess of that.

Help to Buy and Lifetime ISAs are perhaps the least justifiable part of the ISA system. The broader Help to Buy schemes have largely just had the effect of pushing up house prices further without resolving the underlying problems in the housing market [21] and the ISAs which add government top-ups to savings for a deposit are likely to only reinforce this trend. The additional function of Lifetime ISAs, saving for retirement, is an unnecessary addition to pension schemes and again, these schemes are largely exploited to their full by relatively well-off households who are able to set aside significant amounts of money for a long time, in direct contradiction to the original rationale of ISAs. These schemes are a subsidy for the wealthy, indirectly, for homeowners and builders; they should simply be scrapped.

1https://www.gov.uk/individual-savings-accounts

2https://www.gov.uk/individual-savings-accounts/how-isas-work

3https://www.gov.uk/individual-savings-accounts/if-you-die

4https://www.gov.uk/lifetime-isa

5https://www.gov.uk/junior-individual-savings-accounts

6https://www.fool.co.uk/investing-basics/isas-and-investment-funds/historic-isa-allowances/

7https://www.charles-stanley.co.uk/group/cs-live/four-habits-isa-millionaires

8https://gordonandsarahbrown.com/2019/04/the-group-of-savers-who-still-need-most-help-as-isas-reach-20-years-old/

9https://www.theguardian.com/theguardian/1999/mar/27/features.jobsmoney3

10https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/413899/Help_to_Buy_ISA_Guidance.pdf

11https://www.ftadviser.com/pensions/2018/07/26/mps-call-for-abolition-of-lifetime-isa/

12https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/894771/ISA_Statistics_Release_June_2020.pdf