Tax year end retirement saving options - Pension vs ISA vs LISA

The tax year end on 5 April is a natural catalyst for people to make sure they are making the most of their annual contribution allowances and those saving for retirement have a choice to make between pensions, ISAs and Lifetime ISAs (LISA), with each having different rules, allowances and tax benefits.

For those who are employed and qualify for automatic enrolment, saving in your workplace pension – which benefits from both a matched contribution and upfront tax relief – is a bit of a no-brainer.

However, for retirement savings beyond this the choice is less clear cut, with various factors including your income tax band, flexibility and death benefits all potentially shifting the balance one way or another depending on your priorities.

In reality, lots of people will opt for a combination of products to meet their retirement saving needs. The key is to understand how they all work and the various different benefits and drawbacks of each.

How LISAs, ISAs and pensions stack up for people in different circumstances saving for retirement

Scenario 1: Self-employed, under 40, basic versus higher-rate taxpayer

For self-employed basic-rate taxpayers the LISA presents an intriguing retirement saving alternative to a pension.

The LISA offers the same 25% upfront bonus as a pension on the first £4,000 you pay in each year, with the added benefits of tax-free access from age 60 and the flexibility to get at your money earlier if you need it (albeit subject to a 25% Government-imposed early withdrawal charge). You can also access your LISA pot tax-free if you’re putting the money towards a deposit for your first home.

If someone maxed out their LISA allowance from age 18 – paying in and receiving the 25% bonus right up until their 50th birthday - and enjoyed 4% annual investment growth, they could end up with a fund worth around £697,000 by age 68 (which under current legislation would be their state pension age). This entire fund would be available tax-free.

If they saved exactly the same amount in a SIPP, they would end up with an identical £697,000 fund at age 68 – but only 25% of it would be tax-free, with the rest taxed in the same way as income.

The same money paid into a Stocks & Shares ISA and enjoying the same 4% annual growth, on-the-other-hand, would generate a tax-free pot worth around £558,000 by age 68.

However, crucially, higher and additional-rate taxpayers saving in a pension can claim an extra 20% or 25% tax relief from HMRC. So, in the example of a higher-rate taxpayer making a £4,000 annual SIPP contribution, not only would they receive £1,000 basic-rate tax relief automatically but could claim an additional £1,000 from the Revenue.

While any unused LISA and ISA funds would potentially be subject to IHT, the pension could potentially be passed on to your beneficiaries tax-free.

Verdict:

• For a self-employed basic-rate taxpayer LISA provides the biggest bang for your retirement buck and offers more flexibility than a pension
• Pension should be considered for retirement savings above £4,000 and for those prioritising IHT planning
• For higher and additional-rate taxpayers, the ability to reclaim tax relief at your marginal rate shifts the pendulum in favour of pensions
• ISAs are more flexible and could be suitable for medium-term savings

Scenario 2: Self-employed, over 40, basic versus higher-rate taxpayer

As the LISA is only available to those aged 18-39, it is not an option in this scenario – so we are left with a pension or an ISA.

The upfront bonus available from a pension means that the individual will be able to build up a bigger pot versus an ISA. If a 40-year-old saves £4,000 a year in a pension, this will automatically be topped up to £5,000 via basic-rate tax relief.

If they contribute the same amount each year until age 68 and enjoy 4% annual investment growth, they could have a retirement pot worth £275,000. Higher and additional-rate taxpayers would be able to claim extra pension tax relief from HMRC.

If they paid the same subscription into an ISA, by age 68 their fund could be worth £220,000 – some £55,000 less. However, the entire fund would be tax-free, whereas only a quarter of the pension would be tax-free.

Verdict:

• Provided withdrawals are managed sensibly to minimise income tax, the pension should deliver the biggest income for basic, higher and additional-rate taxpayers
• ISA remain provide a handy alternative to pensions – although from age 55 (rising to 57 in 2028) the pension can be accessed as and when the person wants (although 75% of withdrawals will be subject to income tax)
• For those prioritising minimising their IHT bill, pensions also likely to be attractive

Scenario 3: Employed, under 40, basic-rate vs higher-rate taxpayer

Being employed adds a crucial workplace pensions element to the mix – complete not just with upfront tax relief but a matched employer contribution as well.

This shifts the balance decisively in favour of pensions for savings that benefit from this matched employer contribution. This is the case for all taxpayers.

Consider someone earning £30,000 (a basic-rate taxpayer) who is automatically enrolled at the minimum of 8% (for simplicity we’ll ignore band earnings as the Government has stated its intention to remove this by the mid-2020s).

This implies they will make £1,200 of personal contributions each year, with £900 coming via matched employer contributions and a further £300 via basic-rate tax relief – meaning they double their money to £2,400 in a pension.

If the same £1,200 contribution was paid to a personal pension it would benefit from the same £300 tax relief, increasing its value to £1,500 – but it wouldn’t qualify for the £900 matched employer contribution.

Verdict:

• Workplace pensions that qualify for a matched contribution are a retirement saving no-brainer
• For savings over-and-above those that qualify for an employer match, a LISA could be more tax efficient a basic-rate taxpayer
• For higher and additional-rate taxpayers, extra tax relief means pensions are likely to be the optimal choice
• ISAs remain a viable shorter-term savings alternative

Scenario 4: Employed, over 40, basic vs higher-rate taxpayer

The same as scenario 3 but this time the LISA is not an option due to the 18-39 age restriction.

Verdict:

• Workplace pensions that qualify for a matched contribution are a retirement saving no-brainer
• Provided withdrawals are managed sensibly, pension likely to be the best option for all taxpayers for retirement savings over and above those qualifying for a matched contribution
• ISAs again could be used for shorter-term savings