Image source: Getty Images
Many investors contribute to a stocks and shares ISA to earn passive income from the stock market. As there is no tax on dividends from investments held in an ISA, it is a great way to increase returns.
However, for younger investors, there is another wrapper that could be more attractive. I am referring to the Lifetime ISA, which has the benefit of a 25% government bonus on contributions. Nice!
This is how the Lifetime ISA works and why I think qualifying investors should consider opening one to accelerate progress towards achieving their passive income aspirations.
Please note that tax treatment depends on each client's individual circumstances and may be subject to change in the future. The content of this article is provided for informational purposes only. It is not intended to be, nor does it constitute, any type of tax advice. Readers are responsible for conducting their own due diligence and obtaining professional advice before making any investment decisions.
The ISA for life
Investors can open a lifetime ISA before turning 40. After this, they can continue contributing until age 50. Contributions are capped at £4,000 per tax year and the government adds an additional 25%. For those who contribute the maximum amount, this is a £1,000 top-up.
When money is used to buy shares within the Lifetime ISA, the value of those investments will fluctuate. The guaranteed government bonus applies to initial cash contributions.
Lifetime ISAs have restrictions. They are popular with first-time buyers as there are no withdrawal penalties when purchasing your first home for £450,000 or less.
However, their potential as passive retirement income vehicles is overlooked. People over 60 can also withdraw from a stock market portfolio into a Lifetime ISA without penalty.
Maximize my earning potential
To illustrate how advantageous this could be, let's model the effect. For the calculations below, I assume my portfolio grows 8% annually and I would earn a 5% yield on my dividend stocks.
From the age of 18, if I invested £4,000 a year in a stocks and shares ISA, this is what my portfolio would look like when I turned 60.
| Final portfolio | Annual passive income |
|---|---|
| £1,314,332 | £65,717 |
If I contributed to a lifetime ISA until age 50 and used a stocks and shares ISA for the last decade, the figures would look like this.
| Final portfolio | Annual passive income |
|---|---|
| £1,627,270 | £81,364 |
Thanks to compounding returns, you would earn an extra £15,647 in passive income each year without contributing a penny more than if you had simply used a Stocks and Shares ISA.
Of course, share price growth and dividends are not guaranteed. In reality, I may not achieve these goals if my stocks underperform or if the companies I invest in cut or suspend dividend payments.
An investment idea
To achieve my goals, I will need to buy quality dividend stocks. One worth considering is FTSE 250-listed investment platform AJ Bell (LSE: AJB). Shareholders are currently earning a 2.6% yield.
The stockbroker's latest trading update was full of positive numbers. A total of 528,000 customers now use the platform, an increase of 13% in one year. Assets under management have increased by 20% to £83.7bn.
Achieving rapid growth in a highly competitive industry is no easy task. The company's direct-to-consumer (D2C) strategy is paying off.
It is also working with the new Labor government to simplify Britain's ISA system. This could be a boon for the entire sector if Chancellor Rachel Reeves is willing.
Of course, the performance is not too spectacular and the forward price-to-earnings (P/E) ratio of 19.7 seems a bit high, posing risks to share price growth.
But overall, AJ Bell shares are worth consideration – perhaps for a Lifetime ISA offered by the company itself!