Lifetime ISA better than a Pension? 5 key questions to ask yourself

The Lifetime ISA is well-known for helping first-time buyers get onto the property ladder.

But it can also be used for tax-free income from the age of 60. In other words, it can be an alternative savings option for retirement.

We’re all familiar with saving into a pension for retirement, even though the world of pensions can feel overwhelming. Could a Lifetime ISA be a suitable way to save for retirement too?

First of all we need to understand the key differences between saving into a pension, and saving into an ISA in general.

The key difference is in the tax treatment.

ISAs are effectively taxed ‘on the way in’. We’ve typically paid tax on gross earnings before popping some cash into our ISA. Once in the ISA, our money is then shielded from tax. So it becomes tax free ‘on the way out’.

Pensions, on the other hand, are tax free ‘on the way in’. We get a tax saving (or tax relief as it's officially known) equivalent to the rate of income tax we pay on our salary. The pension can grow tax-free and we can 25% of it out tax free, but the majority of the pension is then taxed ‘on the way out’.

So understanding the best ‘bang for buck’ way to save for retirement depends on a number of personal financial considerations.

In general, pensions are the most efficient way of saving for retirement because of the tax benefits we get plus a number of other rules that can make them even more attractive.

But the Lifetime ISA provides a unique benefit in the form of a 25% government bonus, that could make it a better option for retirement savings in some situations.

The Lifetime ISA does have a number of limitations:

1. You have to be aged between 18 and 39 years and 364 days to open a Lifetime ISA.

2. You can only pay into a Lifetime ISA until the day before your 50th birthday.

3. The maximum annual contribution is £4,000.

4. You can’t access it until the age of 60 without triggering a penalty charge.

So here are 5 key questions to ask yourself:

1. Will you want to access your savings before the age of 60?

A) Yes - a pension can currently be accessed from age 55 (increasing to age 57 in 2028), so a pension would offer more flexibility on when you could take out money

B) No - a Lifetime ISA gives you tax-free income from the age of 60

  2. Has your employer maxed out employer contributions into your pension?*

A) Yes - you’ve already got as much ‘free money’ as you can from your employer

B) No - by increasing your personal contributions into your workplace pension, your employer will also pay more in. A fantastic benefit to make the most of.

*Note that if you’re self-employed, this question is irrelevant.

   3. Are you either a non taxpayer or basic rate taxpayer?

A) Yes - the tax benefits of paying into a Lifetime ISA vs a Pension are effectively the same on personal contributions. But the Lifetime ISA gives you greater tax-free benefits on withdrawal.

B) No - if you’re a higher rate or additional rate taxpayer, saving into a pension gives you greater tax savings.

    4. Do you use a salary sacrifice scheme for paying into your workplace pension?

A) Yes - with the additional national insurance savings using a salary sacrifice pension arrangement, it’s more effective paying into this pension than a Lifetime ISA

B) No - depending on the rate of income tax you pay, a Lifetime ISA could be a good option

      5. Do you expect your taxable annual retirement income, including state pension payments, to exceed your personal allowance? (Currently £12,570)

A) Yes - this means any income from a pension over £12,570 will be subject to income tax excluding any tax-free cash you take (25% of the overall pension value).

B) No - a pension would still be tax-free even after you’ve used up your tax-free cash entitlement.

There is really only one scenario, factoring in all your answers, that would make a Lifetime ISA a better option for retirement savings.

1. No

2. Yes (or not irrelevant if self- employed)

3. Yes

4. No

5. Yes

If your answers match these, then a Lifetime ISA would be well worth considering. 

This is because:

1. You don’t need income from it before you’re 60

2. Your employer has already maxed out their contributions into your pension, so there is no further ‘free money’ to be had

3. You’re a non taxpayer or basic rate taxpayer, so the government bonus in the Lifetime ISA is equivalent to the tax saving you’d get from paying into a pension.

4. You don’t have a salary sacrifice pension arrangement, so you won’t get additional tax savings with pension contributions into your workplace pension.

5. You expect your taxable pension income to be higher than the personal allowance, which means some of your pension would be taxed. Bear in mind 25% of your pension can be withdrawn tax free.

Summary

There are various other things to consider regarding investment choices within a Lifetime ISA, costs and choice.

But some providers will let you open one with as little as £1. So for a £1 investment on something that is time sensitive, it could be a great way to spend £1 before your 40th birthday. Even if you never use it beyond that, its opened up another option for your future,