The ISA has long been an incredibly attractive way for UK investors to shield their investment income and capital gains from all taxes.

The annual contribution limit has risen over the years, too. From 6 April 2017 you’ve been able to sock away £20,000 a year.

Some or all of that allowance can now go into an Innovative Finance ISA. Similar to a cash ISA, this enables you to shelter the higher income you can get from peer-to-peer platforms from tax (although big boys Ratesetter and Zopa have yet to win approval for theirs).

The ISA has also become a weapon of redistribution, albeit one with a distinctly Tory slant.

First came the Help to Buy ISA, which tops-up the savings of first-time buyers. Help to Buy ISAs became available in late 2015.

And then 6 April 2017 saw the launch of the Lifetime ISA – also known as a ‘Lisa’.

The Lifetime ISA / Lisa enables young (and young-ish) people to save up to £4,000 every year into a special new ISA wrapper. This money is then boosted by the Government by 25%.

• For example save the maximum £4,000 and they’ll give you £1,000. That would mean £5,000 went into your Lifetime ISA that year.

The money in your Lifetime ISA grows tax-free, as with normal ISAs. It can later be used to buy your first home or else be put towards retirement.

Here it is illustrated in one official government graphic:

This graphic is actually a bit misleading. It implies the bonus is static, whereas the Treasury’s own documents make clear the bonus becomes part of your total Lifetime ISA pot that compounds over the years. Also, from April 2018 the bonus will be added monthly.

Anyway, free money growing safe from taxes sounds great, right?

Well, it might be, but complications abound with the deceptively simple Lifetime ISA and there are harsh penalties if you stray off-piste.

In this article we’ll dive into the detail of the Lifetime ISA. In the follow-up I’ll look at who should make the Lifetime ISA a big part of their savings strategy, and who should probably not.

(Spoiler alert: I think everyone who can open a Lisa should do so, but in many cases with just the minimum contribution allowed. For example Hargreaves Lansdown will let you open one with just £100. This way you have it should your circumstances change, even after you’re too old to be allowed to open a new one).

The Lifetime ISA explained

Let’s run through the key points.

Opening a Lifetime ISA:

• You must be aged between 18 and 39.
• You must be a UK resident. ((Or a member of the armed forces serving overseas, or their spouse or civil partner))
• You can only open one Lifetime ISA per person, per tax year. ((Each time you apply for a new Lifetime ISA you’ll need to meet those first two criteria. After your 40th birthday, no more new Lifetime ISAs for you! However you can continue to contribute to your existing ones until you’re 50.))

You can open a Lisa if you’re just one day shy of your 40th birthday (and as mentioned I think you should).

After that, computer says no.

How much can you put in?

• You can save up to £4,000 a year into your Lifetime ISA(s).
• Any cash you put in it before your 50th birthday will receive an added 25% bonus from the government.
• The first government bonuses will be paid into your Lifetime ISA account in April 2018.
• From then on bonuses will be paid monthly.
• Once in your Lisa, the bonus earns interest (or can be invested) just like the money you contribute yourself. This nicely increases the total pot you’re compounding.
• For the 2017-18 tax year only, you can transfer savings you’ve built up in a Help to Buy: ISA into a Lifetime ISA in that year and still save up to £4,000 into your Lifetime ISA and get the government bonus. ((Alternatively you can keep saving into both schemes. However note you will only be able to use the bonus from one of the ISA types to buy a house!)) See MoneySavingExpert for some ideas on timing.
• You can save into a Lisa until the day before your 50th birthday. After that it can remain invested, but you can’t put new money in (and you’ll get no more bonuses).

The showstopper attraction then is you get an added £1 for every £4 you put into the Lifetime ISA per year, up to the £4,000 limit.

That’s much better than with a normal ISA, where you pay in taxed money and get no extra top-ups.

Indeed it’s free money – always the safest return. ((Okay, it’s not totally free as the government must get the money to top-up from somewhere, via taxes. But if you’re young it will probably be coming from taxing someone older.)) For the youngest Lifetime ISA savers, it could add up to tens of thousands of pounds of bonus payments over the decades (presuming the scheme survives.)

If you begin at age 18 and you save the full £4,000 a year, then at 50 you’d have saved £128,000 and enjoyed £32,000 of top-ups. (And that’s just the money that’s gone in, before any growth…)

There are no minimum or maximum monthly contributions to the Lifetime ISA. You should be able to save whatever you want each month, up to the £4,000 a year limit.

What about my other ISAs?

The larger £20,000 annual ISA limit applies across all your ISAs – Lifetime ISA, Help to Buy ISA, Innovative ISAs, and, um, Bog Standard ISAs.

For example, if you put the full £4,000 in a Lifetime ISA, you have £16,000 of your allowance leftover for the rest of the ISA gang that year.

How can I invest my Lifetime ISA money?

Qualifying investments for a Lifetime ISA are the same as for a normal ISA. Cash, shares, bonds, investment trusts, ETFs, funds – all should be fair game.

This means that unlike with a Help to Buy ISA (which is limited to cash) as a Lifetime ISA owner you can take your government-sourced money and pump prudently invest it into shares.

However there’s a snag. In theory, all those assets I listed can be held in a Lifetime ISA – but currently there are no cash Lifetime ISAs available.

This is a pretty strange state of affairs, and it won’t last if the Lifetime ISA survives.

In the meantime, if you are risk averse (perhaps because you think you’ll need the money in a few years for a house and you don’t want to risk the ups and downs of the stock market) you could perhaps open a Lifetime ISA that’s meant for shares, and invest your money and the bonus in a short-term bond ETF.

Or you could just wait for cash Lisas to become available.

How you can use your Lifetime ISA

At last the good bit! You can use the money in your Lifetime ISA in two different ways:

To buy your first home

• Your savings and interest and the government bonus – all compounded together over the years – can be put towards a deposit on your first home. This property can cost up to £450,000, anywhere in the country. ((Unlike the Help to Buy ISA, which has different limits inside and outside of London.))

• If you’re in a couple you can both receive the Lifetime ISA bonuses before buying together, as ISAs and top-ups are limited per person rather than per home. The maximum house price remains £450,000 for a couple, though.

• If you have a Help to Buy ISA you can transfer those savings into your Lifetime ISA in 2017-18, or else continue with both. However you will only be able to use the bonus from ONE of these two kinds of special ISAs to buy a house, which could lead to fiddly complications or decisions down the line.

This last point begs the question of what else to do with your Lifetime ISA money if you don’t buy a house?

Aha! That brings us to the second permitted use…

Put it towards your retirement / later fund

• After your 60th birthday you can take out any or all the savings in your Lifetime ISA, tax-free.

The official line is you will be able to leave the money invested if you want to after you’re 60. You should also be able to transfer your money to another type of ISA.

For example, perhaps Innovative Finance ISAs will be providing would-be retirees with a steady tax-free income and various safeguards in two decades time?

Frankly, who knows what the landscape will look like in 20 years. (Just one reason why constant government tinkering is unhelpful. It adds more uncertainty.)

Assuming the ISA regime survives until 2037 and beyond, I expect that when the first Lisa owners hit 60 there will be lots of options.

What if I don’t buy a house and I want the money before I’m 60?

Now we come to the big sting in the tail – the potential penalty charges.

You can withdraw your Lisa money without a charge if:

• It’s to go towards your first home costing up to £450,000, and it’s been 12 months since you first started saving into the Lifetime ISA.
• Or you’re over 60.
• Or you’re terminally ill.

Otherwise, you face a penalty.

• You will have to pay a withdrawal charge of 25% if you take out money at any time before you turn 60 (unless it’s to buy a qualifying house).

This charge is tougher than you might first think.

Some will see a 25% charge as simply clawing back the 25% Government bonus.

But this is not right. Here’s the maths:

Put in £4,000
Get £1,000 bonus (that is, a 25% boost).
You now have £5,000
Withdraw early, for non-permitted reasons
Take a 25% charge = 25% of £5,000 = £1,250
£5,000 – £1,250
= £3,750

You are left with less money than you put in! (6.25% less to be precise, which is the true penalty for withdrawing after taking into account the bonus).

This is a simplified example. There’s a 30-day cooling off period when you open a Lisa, and there will be no exit penalties charged in this first year. Over sensible time periods there’d hopefully be some growth in your money.

But the principle holds. You might find you have to withdraw money early – and the freedom to do so, even with a charge, is attractively flexible compared to a locked-up pension – but you really don’t want to if you can help it.

If you start a Lifetime ISA, you need to be as confident as possible that you will abide by the rules: Buy a first home with the money, or no withdrawals until 60.

Where can I get a Lifetime ISA?

Only a few providers are offering them so far. Right now Hargreaves Lansdown, Nutmeg, and The Share Centre. That’s your lot.

Seems odd, doesn’t it? Former chancellor George Osborne announced the Lifetime ISA back in the 2016 Budget. Plenty of time for platforms to get on-board – especially when they can dangle carrots of free cash from the government in front of savers.

Theories for the tardiness abound:

• Perhaps the new HMRC reporting regime for Lifetime ISAs is proving onerous?

• There are concerns over those exit penalties (belatedly softened for the first year).

• The first lump sum top-up from the government won’t be paid until the end of the year, so what’s the rush?

• Some fear the Lisa could be the next mis-selling scandal.

Then there’s my theory, which is that the Lifetime ISA is such a muddle that firms presumed it would be scrapped before launch. (A tad naive when it comes to finance, perhaps. When has confusion ever stayed the industry’s hand?)

Don’t get me wrong. The Lisa has its attractions. The initial pros and cons aren’t going to be hard for a typical Monevator reader to figure out.

However extrapolating them over an uncertain 10-30 year time horizon is harder.

Meanwhile the average young person is likely to be bamboozled from the outset.

Should you open a Lifetime ISA?

At first glance, the Lifetime ISA sounds like a Help to Buy ISA with a personality disorder, but that doesn’t mean it’s not worthy of close attention.

As it can only opened by those aged 18-to-under-40, it seems to be aimed at helping the finances (and winning the votes) of a younger generation that has seen job security, affordable housing, and generous final salary pensions disappear over the horizon.

Whether the Lifetime ISA is the best way to address wealth inequality across the generations is a topic for another day.

But if you’re young enough to qualify and you have money that you’re committed to locking away either to buy a home or for your retirement, you should give serious thought to opening a Lifetime ISA.

As I say I would definitely open one if I were under 40, even if it was only to put £100 into it. Once it’s opened, you have the option of using it once you’re over 40, and who knows how your circumstances might change? Don’t open it, and the door closes on your 40th birthday.

All that said, weighing up whether you should be directing money towards a pension (particularly a workplace pension with super valuable employer contributions), a Lifetime ISA, a Help to Buy ISA, a normal ISA, or some other form of savings will be complicated for many people.

Not least because the two uses permitted – buying a home when young, and saving for when you’re old – entail very different investing decisions.

And also because of that exit penalty, of course.

In the next post we’ll see exactly who the Lifetime ISA might be good for, and who should say “no thanks”, and back away slowly.

Note: I’ve updated this post with all the latest on the Lifetime ISA. Older comments below this post may date back to its launch. Many are still relevant, but keep that in mind.

Good reads from around the Web.

Often it feels like the best thing to do as a writer about investing is to repeat what you said last week.

In a Bloomberg podcast I link to below, the entertaining hosts bemoan how boring the markets are right now. That’s understandable – they’re both journalists, and they want to write about drama.

Nobody becomes a journalist to say “nothing doing here, as you were”. But that’s actually pretty good advice to live by when it comes to investing.

While The Accumulator continues to labour away on his book, I’ve republished some of his old articles to remind people what we’re missing. Frustratingly, TA has a habit of putting in useful contemporaneous snippets of data when he writes (whereas I try to wax eternal, like a Poundshop Marcus Aurelius). Many of his older pieces can’t just be dusted down and passed off as new. But more than a few can, because the best financial principles are timeless.

The alternative is to just keep saying the same thing, but to try and say it better each time. This is hard. Shakespeare’s 150-odd sonnets go over the same ground as doggedly as a Roomba, but they don’t really get better as you go on. And I’m no Shakespeare.

The third approach (and the motivation for these weekly roundups) is to see how other people approach the same topics, and to applaud them when they knock it out of the park.

Which brings me to Just Keep Buying, a piece this week from the Of Dollars and Data blog. It sees the anonymous author (hey, I already feel a kinship) approach the age-old topic of dollar-cost averaging with a mix of succinct prose and revealing graphics.

This is the best bit:

If I still haven’t convinced you [to just keep buying each month] let me tell you a story.

The story is about a man with possibly the worst luck in investing history. He made a total of 4 large stock purchases between 1973 and 2007. He bought in 1973 before a 48% decline in stocks, bought in 1987 before a 34% decline, bought in 2000 before the dot com crash, and bought in 2007 before the Great Recession.

Despite these 4 individual purchases that totaled a little less than $200,000, how did he do? He ended up with a $980,000 profit for a 9% annualized return.

What was his secret? He never sold.

I’d go and read the whole article if I were you.

[continue reading…]

Skepticism is a valuable trait in an investor. This doesn’t mean you should always be pessimistic, but you should question the status quo. Skepticism helps you step outside trends of the day and take a more objective view.

I’m not, therefore, surprised that some thoughtful minds have criticized the surging popularity of dividend investing in recent years.

A fresh round of dividend criticism is a good thing. It is important for us to challenge our assumptions.

Dividend doubters

Some vocal dividend skeptics include Larry Swedroe of The BAM Alliance, who has called investor preference for dividends “irrational,” and financial journalist Matt Yglesias, who bluntly called dividends “evil.”

Ouch! As much as we might want to disregard such positions, these commentators and others in their camp make some fair points.

Here are my thoughts on the more popular criticisms of dividends.

1. Shareholders should applaud share buybacks

One argument voiced by the dividend doubters runs as follows: If you’ve invested in a company, you should not mind if it is buying back its shares instead of paying dividends.

Frankly, this is the anti-dividend crowd’s best argument.

In principle, by holding a stock you are implicitly saying you would buy the stock again today. Otherwise, you should sell the stock if you think the price is too high.

As such, you should not be upset with the company also repurchasing the stock at the current price.

To see why this is not a knockout punch to dividends, we need to recognize a few things:

• Investors and capital allocators (managers) typically have different motivations

• Investors are working with only public information; managers possess non-public information

• Investors may reasonably decide to hold on to a slightly overvalued stock

• A buyback made at a discount to a stock’s intrinsic value is a wealth transfer from selling shareholders to ongoing shareholders; the opposite is true if the stock is overvalued

• A dividend has the same wealth transfer effect as a buyback made at fair value – it treats ongoing and selling shareholders equally

Ideally, management teams would follow a fair value discipline with buybacks, but they often have other, less attractive motivations.

These can include supporting earnings per share growth to meet broker estimates, to offset dilution (stock options and so on), or to manage firm leverage. A buyback, then, doesn’t necessarily signal anything about the company’s underlying value.

To be fair, if you suspect the management team is buying back stock primarily for these reasons, you might question why you own the stock in the first place.

Even so, a dividend investor should be perfectly content holding onto what he or she perceives to be a slightly overvalued share in a great company. This is because the odds that you’re right about the share’s fair value are much lower than the odds that you’ve correctly assessed the company’s quality.

I’d wager all of us – and this is certainly true for me – have sold a great dividend-paying company on short-term valuation concerns only to watch the stock (and its dividend) march onto higher gains in the years ahead.

In a perfect situation, we’d sell at a high price, the stock price would quickly correct, and we’d be more than willing to buy it back at a lower price. In practice, we know this isn’t typical. Either our valuation work was wrong, the stock continued to rise anyway, or we failed to seize on the opportunity to buy it back later.

Does this mean that management should follow the same logic and knowingly transfer wealth from ongoing to selling shareholders?

Absolutely not! If they have excess capital on the back of a good year and they feel their stock doesn’t present good value, they could retain the capital or pay a special dividend.

2. Dividends are depriving companies of value-enhancing capital

This statement is only true if you believe management could reinvest the ‘lost’ capital at high-rates of return.

First, it requires the company to have an abundance of high return projects. But mature companies that generate a lot of cash flow may not have enough high return projects available. I believe whatever capital the company can’t reinvest at attractive rates should be returned to shareholders.

Second, this statement requires a belief in management’s capital allocation skill. Fact is if all management teams were strong capital allocators, we wouldn’t see as many restructuring and impairment charges as we do.

Simple statistics would also suggest outstanding capital allocation skill is quite limited:

If we think about the capital allocation skill of management teams across the market as a normal distribution (see the illustration above), we can conclude that only 2.5% of them are exceptionally skilled (two standard deviations above the mean). Another 13.5% are good allocators (between one and two deviations above the mean), 34% are fair-to-good, and the remaining 50% are sub-par.

The top 2.5% of management teams should be able to retain all of the company’s free cash flow to reinvest as they see fit. The odds are pretty good that this cohort could do more with the capital than we could.

For example, I’d put Berkshire Hathaway’s Warren Buffett and Charlie Munger in this camp – and as a Berkshire Hathaway shareholder myself, I presently have no issue with the company not paying a dividend for this very reason.

The other 95% of companies should pay varying levels of dividends to shareholders, either because they don’t have enough good reinvestment opportunities or they don’t have a strong investment mentality.

Many management teams rise through the ranks based on qualities (marketing, sales, operations, and so on) that may be of great value to the business, but this doesn’t necessarily mean they are great investors or capital allocators.

The presence of a progressive dividend policy (a stated goal of increasing or keeping the same level of dividends each year) can serve as a check on empire building by management. Capital rationing may actually be a net positive for some management teams who, being forced to work with less capital, allocate the remaining capital more efficiently than they would have with 100% cash flow retention.

In fact, I once heard it brilliantly argued (regrettably I forget by whom) that companies should distribute all free cash flow as dividends and then convince shareholders to give them the money back when they have an attractive investment opportunity.

It’s not practical, of course, but I agree with the logic.

3. You can create your own dividend by selling shares

It’s true that if you want to generate 4% cash from your investment, you can sell 4% of your shares and create a ‘dividend’. Shareholders are making the quasi-dividend decisions in this scenario, the thinking goes, and so companies are relieved of forming dividend policies.

The first problem with this philosophy is that it doesn’t adequately address the downside of the previous point.

You’re still entrusting management to reinvest all of its capital in value-enhancing projects or buying back its stock at good-to-fair prices. This is far from a sure thing.

Second, this DIY selling route may not be cost-effective for smaller investors.

Let’s say you have £10,000 invested in a share and you want to create a 4% dividend by selling £400 worth of the position each year. Unless your broker fees are less than £4 per trade, this trade would cost more than 1%.

Whilst broker fees are trending lower, there are not many brokers with share trading costs that low.

Finally, one of the attractive features of dividends is that you don’t need to make regular sell decisions (and rack up fresh trading costs with each sale) if you want an income.

The distribution of regular dividends frees investors from having to make unnecessary decisions in the first place.

An investor with a 20 share portfolio who wanted to create semiannual dividends would need to make 40 sale decisions each year. With quarterly dividends, the trades double to 80.

Given the heavy biases and emotions tied to sale decisions, there’s a good chance that you’d mishandle at least a few of those 40 to 80 sales.

4. Investor preference for dividends is illogical

Dividend critics often point to some behavioral biases that can occur with dividend investing.

These include mental accounting (treating income and capital returns differently), regret avoidance, and an inability to defer gratification.

For starters, I cannot think of a single investment strategy that wouldn’t come with a unique set of biases. To be human is to be biased. It is just a fact that we need to recognize and appreciate. The better we acknowledge these biases and consider them before taking actions, the better our outcomes will be over extended periods of time.

Moreover, while mental accounting has its downsides, anything that takes investors’ minds off short-term market price moves and instead focuses them on the prospects of the underlying businesses they own is a net positive.

Let’s say your stock portfolio was down 20% in a given year due mainly to a broader market sell-off rather than any big change in business fundamentals. To an investor focused solely on ‘total return’, this might easily result in panic and poor investment decisions.

If instead that same investor noticed their portfolio was now producing higher dividends than in the prior year – and that the dividend yield on their diminished capital was effectively higher, too – they could reasonably conclude that the underlying businesses are doing just fine. As a result, this investor could have better odds of staying calm in a challenging environment.

Regret avoidance speaks to an investor’s aversion to selling shares to create a dividend because they fear what would happen to the stock after they sold. If they sold 3% or 4% of their shares and the stock subsequently rallied, they would be upset with their decision. On the other hand, if they received a 3% or 4% dividend, they would consider the rally outside of their control.

I have no doubt this is true. As previously discussed though, I think investors likely benefit from not having to make too many decisions. Fewer and better decisions should be the mantra of all long-term investors.

Finally, in my experience speaking with and learning from other dividend investors, I can confidently say that an inability to delay gratification is not a common trait of the group. On the contrary, the hallmark of dividend investing is patience.

5. Dividends are not tax efficient

This depends on in which country you’re investing and where the company you own is based.

Much is written about dividends and taxation from a US perspective, but it’s important to realize that different countries around the world treat both income and capital gains in varying fashions.

The U.S., for example, has a ‘double taxation’ issue when it comes to dividends, whereby profits are taxed at the corporate level and then again at the individual level.

Some other countries, however, provide some tax credits to individuals receiving dividends that reduce or eliminate double taxation.

Further, the investor can mitigate the tax impact of dividends by holding dividend-paying shares in tax-efficient wrappers like ISAs and SIPPs in the UK, or IRAs in the US.

Dividend investors looking across the globe for investment ideas should take note of any tax withholding required by foreign governments. They should consider their country’s tax laws and treaties to determine the right type of account (tax-deferred or not) for their foreign dividend stocks.

I would agree with critics that it’s important to be mindful of any tax drag dividends might have on your returns. Many of the studies that show dividends accounting for the majority of long-term shareholder returns assume full dividend reinvestment and don’t take taxes or trading costs.

The smaller the percentage of the dividend you invest back into the share that paid it due to taxes, the less you realize of the share’s ‘total shareholder return’.

Wrapping it up

You’d be hard-pressed to find a successful investor who doesn’t appreciate the value of dividends. There’s also plenty of academic research supporting the role dividends play in long-term returns.

For example, the following graph indicates that higher-yielding shares have outperformed lower-yielders over the long-term:

Source: Credit Suisse Equity Yearbook 2017

We dividend-minded investors shouldn’t rest easy. Markets, investor preferences, and corporate finance regularly change, and dividend investors must be prepared to address these changes anew with clear eyes.

With time, dividends will fall in and out of favour, but there’s nothing wrong with them in themselves. I believe they remain a long-term investor’s best friend.

Todd Wenning, CFA is an equity analyst based in the United States. Opinions shared here are his own and not those of his employer. A full disclaimer can be found here. For compliance purposes, Todd cannot reply to comments below, though he welcomes any correspondence sent by email. You can read Todd’s expanding collection of dividend articles here on Monevator or check out his book, Keeping Your Dividend Edge.