Is a Lifetime ISA a good alternative to a pension?

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Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

Getting the biggest bang for your retirement buck will be one of the key considerations for people choosing where to invest their hard-earned savings.

For those who are happy to lock up their money until later in life, it is a straight fight between LISAs and SIPPs – both of which provide an upfront savings incentive.

The starting point for most people regardless of their tax bracket should be their workplace pension.

In fact, someone earning £30,000 who contributes 8% of earnings in total could have a fund worth £140,000 after 30 years. If the equivalent personal contribution of £1,200 a year was paid into a LISA - but without the benefit of a matched employer contribution – it could be worth £87,000 after 30 years.*

In other words, someone earning roughly the average UK salary who opted out of automatic enrolment and put their money into a LISA instead could end up with a pot worth 38% less as a result.

However, for those who do not qualify for auto-enrolment – such as the self-employed – or for savings outside of workplace pensions the equation is more marginal and will depend in part on whether they are a basic or higher-rate taxpayer.

LISA vs pension outside auto-enrolment – basic-rate taxpayers

For basic-rate taxpayers saving outside auto-enrolment the LISA offers an intriguing alternative to a pension. It provides exactly the same 25% upfront savings bonus, but crucially withdrawals are tax-free from age 60.

Pensions, on-the-the-hand, can be accessed from age 55 at the moment, with a quarter available tax-free and the rest taxed in the same way as income.*

So, where the same upfront bonus has been added each year, the key difference from an income perspective between the LISA and pension will be how withdrawals are managed in retirement.

If taxable pension withdrawals are taken within the personal allowance it is possible the pension and LISA will deliver a similar level of income. However, if pension withdrawals are above the personal allowance and subject to income tax, it is likely the LISA will deliver more income in retirement.

LISA vs pension outside auto-enrolment – higher-rate taxpayers

The equation changes for higher-rate taxpayers, however, as they are able to claim extra tax relief each year.

A higher-rate taxpayer who paid £1,200 a year into a pension could end up with a fund worth £87,000 after 30 years –the same as they could build in a LISA.

However, crucially they could also claim back an extra 20% tax relief – or £300 a year in this example – via their pension which they would not get from their LISA. If that £300 were invested in an ISA each year, it could generate a tax-free pot worth £17,000 after 30 years.

Thinking beyond income tax

There are other differences between LISAs and pensions that should factor into people’s thinking when deciding which is right for their hard-earned savings.

In most cases SIPPs benefit from a much higher annual limit of £40,000, compared to £5,000 (including the Government bonus) for LISAs.

For those who have breached either their annual or lifetime allowance for pensions, a LISA could be a good option for any extra savings they have.

SIPPs also benefit from generous tax treatment on death, meaning they can potentially be passed on to your nominated beneficiaries tax-free. Funds held in LISAs, on the other hand, will form part of your estate for inheritance tax purposes.

The point at which you can access your money is also slightly different. SIPPs cannot be touched until age 55 – rising to age 57 in 2028 – while early LISA withdrawals for anything other than a first home purchase or if you become terminally ill will be hit with an early withdrawal charge by the Government. But LISAs do give you flexibility to access your fund early – albeit with a penalty - if you need to.

Because each product has slightly different rules, strengths and weaknesses, a combination of both pensions and LISAs – and indeed traditional ISAs - might be the best approach.

To open a LISA, you need to be aged at least 18 and under 40. Having opened a LISA account, you can keep paying in until the day before your 50th birthday.

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*Source: AJ Bell Analysis

Important information: These articles are for information purposes only and are not a personal recommendation or advice. How you're taxed will depend on your circumstances, and tax rules can change. ISA rules apply. A Lifetime ISA isn't for everyone. If you withdraw money before age 60, unless it's to buy your first home, you'll pay a government withdrawal charge of 20%. Please note, the withdrawal charge is changing to 25% from 6 April. And if you choose to save in a Lifetime ISA instead of enrolling in, or contributing to, your workplace pension scheme, you'll miss out on your employer’s contributions. Your current and future entitlement to means-tested benefits may also be affected. How you're taxed will depend on your circumstances, and tax rules can change. Pension rules apply.


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Written by:
Tom Selby

Tom Selby is a Senior Analyst at AJ Bell. He is a multi-award-winning former financial journalist specialising in pensions and retirement issues. Tom has over five years' experience working at Money Marketing magazine, where he became the Head of News in 2014. He has a degree in economics from Newcastle University.