Pensions and lifetime ISAS compared
The Lifetime ISA (LISA) became available in April 2017, giving those under 40 a new savings option. How does it stack up against the traditional retirement savings plan; the pension?
The LISA is billed as a dual purpose product attempting to overcome the younger generation’s dilemma of which to save for, a house or a pension. The answer will usually be “both” of course but whether that is best achieved in one product is another question.
For those saving for their first home, there’s little doubt that the LISA is an attractive option, but how does it compare with a pension for its other intended purpose - retirement planning?
Eligibility, contribution limits, bonus and reliefs
The eligibility requirements and bonuses are much more restrictive for the LISA than a pension. To take out a LISA you must be at least 18 years old and under 40. The bonus is a fixed rate of 25% but limited to a maximum of £1,000 a year. The maximum contribution is £4,000 topped up with the bonus to £5,000. In addition, the bonus only applies up to age 50.
Contributions to a LISA will count towards the increased £20,000 overall ISA limit for 2017/2018.
In contrast there are no minimum age limits required to benefit from personal tax relief on a pension and this can continue up to age 75. The contribution limits are also much higher - the standard annual allowance is £40,000. However, for high earners the annual allowance may reduce to as low as £10,000 a year.
Tax relief is available on personal pension contributions at the individual’s highest marginal rates. For basic rate taxpayers this is the equivalent to the 25% bonus offered on the LISA. For higher and additional rate taxpayers, it will be greater.
Investments and investment taxation
Neither the pension or LISA are subject to tax on income or gains whilst invested making both very tax efficient. Both LISA and pensions can provide a wide range of investment options.
Access and penalties
Unless used for the purchase of a first home, penalty free access from the LISA isn’t available until age 60. Funds withdrawn earlier are subject to a penalty charge of 25%.
Pension funds can’t normally be accessed until the member reaches 55 (57 from April 2028).
The ability to access the LISA before retirement may be seen as an advantage for some savers; however, this is only available at a relatively high cost.
Tax on benefits
The big advantage of the LISA is that if funds remain invested until at least age 60, there is no tax to pay on the withdrawals. With a pension, you can take up to 25% of your pension savings tax free. The rest will be subject to income tax as your marginal rates.
Pension freedoms allow complete flexibility in how and when benefits are taken once you have reached the minimum retirement age. This can help manage the tax position on withdrawal of funds but is unlikely to match the tax free LISA.
Employer contributions
LISAs can’t accept employer contributions. Increasingly employers are offering the option to facilitate ISA contributions for employees and this may be extended to LISAs, however, they offer no tax advantages over taking the taxed salary and investing directly.
The big advantage for pensions is that most (and eventually all) employers have to make minimum contributions into a pension scheme. The employer contribution, even at automatic enrolment minimum levels will mean the pension should provide far greater benefits on matched contributions (see table below).
Death benefits
Pensions have advantages in relation to death benefits. The benefits from a pension are normally outside of the member’s inheritance tax (IHT) estate whereas with a LISA they will form part of the estate.
How do the numbers stack up for employees?
The table below looks at an employee earning £25,000 a year. They are a basic rate tax payer now and it is assumed they still will be when they retire.
In one scenario they invest £1,000 in a LISA.
In another scenario they invest £1,000 in their workplace pension (assumed contribution levels of 5% employee and 3% employer).
| LISA | PENSION WITH EMPLOYER CONTRIBUTION | PENSION WITH EMPLOYER CONTRIBUTION AND EMPLOYEE NATIONAL INSURANCE CONTRIBUTIONS* | |
|---|---|---|---|
| Initial investment… | £1,000 | £1,000 | £1,000 |
| …plus tax relief / bonus / employer contribution | £250 | £1,000 | £1,1500 |
| Total invested | £250 | £1,000 | £1,1500 |
| …plus tax relief / bonus / employer contribution | £1,250 | £2,000 | £2,150 |
| Tax paid on withdrawal in retirement | £0 | £300.00 | £322.50 |
| Money left for retirement | £1,250 | £1,700 | £1,827.50 |
| Pension V LISA % | +36% | +46.2% |
* Assumes salary sacrifice where 12% of employee contribution level NI saving is added. Actual levels can be higher.
This demonstrates that with employer contributions, the pension produces a far greater result than the LISA. The differential for a higher rate taxpayer would be even greater still.
Once an individual is saving enough in a pension to maximise employer contributions and can afford to save more, they may choose between further funding the pension or using a LISA. From a tax point of view, the advantages of each option would depend on the rate of tax they pay now and the rate they expect to pay in retirement.
Information correct as at June 2017