Should I save into a Lifetime ISA or a pension for my retirement?

In many recent client meetings, I have been asked by individuals whether they are better off saving into a pension or a Lifetime ISA for their retirement. Which one works better for you depends on your individual circumstances/tax position.

Let’s start with the differences.

Lifetime ISA (LISA) recap:

• This is an account that can be in cash or invested, and your money has the chance to grow free from UK income and capital gains tax.
• You can open an account between the ages of 18-39 and make contributions up until age 50.
• You get a 25% bonus of up to £1,000 every tax year. You can put £4,000 in total into the account per tax year, which contributes towards your overall ISA allowance of £20,000.
• You’re free to take money out at any age if you need to, but there will normally be a 25% penalty (bigger than your initial bonus) for withdrawals that aren’t used towards an eligible first home purchase or before the age of 60
• Withdrawals are all free of income tax.

Pension recap:

• This is an account where your money has the chance to grow free from UK income and capital gains tax.
• You can open an account from age 18, and there is no upper age limit.
• A parent or guardian can also open a junior account for a child under 18.
• You can make tax-relievable contributions until age 75.
• You can get up to 45% in tax relief on pension contributions.
• Pay in up to £60,000 each tax year (certain limits apply – see below).
• Take money out from age 55 (rising to 57 in 2028).
• 25% is usually tax-free; the rest is taxed as income.

What about if you have a workplace pension?

• As a general rule, if your employer offers a workplace pension, it can make it very advantageous to save for your retirement.
• Under auto-enrolment, your employer is legally required to contribute an amount equal to at least 3% of any qualifying earnings (providing you’re eligible), and lots of employers will match anything that you pay into your pension up to a certain limit. Check what your limit is!
• You also get tax relief on your pension contributions, which will be at your highest marginal tax rate, plus NI with a salary sacrifice arrangement.
• If your employer is already contributing the maximum, or they won’t pay in more, then whether a pension or LISA will be most tax efficient for you will depend on your personal circumstances – factors like your salary and tax situation.

What if you earn less than £50,270 per annum?

• For a basic-rate taxpayer (less than £50,270 pa), once you’ve maximised the pension contributions from your employer, it could be more tax efficient to pay £4,000 of your retirement savings into a Lifetime ISA, assuming they don’t offer a salary sacrifice arrangement.
• With a salary sacrifice arrangement, you won’t have to pay NI on your pension contributions in addition to the income tax relief. By using salary sacrifice, your employer also saves on NI, and some firms will contribute some or all of these savings to your pension.
• When you come to make withdrawals from the LISA after age 60, they’ll be completely tax-free because you’d have already paid income tax on your earnings before you paid the money into your LISA (e.g. through PAYE). In contrast, when you take money from a pension, usually only up to 25% is tax-free, and the rest (75%) is taxable income.
• For example, let’s say you pay £4,000 into a LISA for 10 years. You would have a pot worth £50,000 from which you could withdraw entirely tax-free from age 60, having paid only £40,000.
• If you paid the same amount into a pension, you would also end up with a pot worth £50,000. That’s because the basic-rate tax is currently 20%, and you would get basic-rate tax relief on contributions, subject to limits.
• However, when you came to take the money out of a pension, you would only get up to £12,500 tax-free, with the rest taxed as income – meaning you would likely face 20% tax on the remaining £37,500. You may also have other taxable income such as state pensions, defined benefit pensions, rental income, etc.
• This is just an example. It doesn’t account for any investment growth, loss, or charges. Remember, unlike the security offered by cash, investments can fall as well as rise in value, so you could get back less than you invest. The value of cash can be eroded by the impact of inflation over time.

What if you earn more than £50,270 per annum?

• If you’re a higher-rate taxpayer or above, you’ll usually be better off paying extra retirement savings into a pension, because the extra tax relief you can get on pension contributions will offset the tax you pay on withdrawals later.
• This assumes that you’ll be a basic rate taxpayer in retirement. The LISA 25% bonus is effectively the same as a basic-rate taxpayer’s pension tax relief. However, as a higher earner pre-retirement, you can claim more tax relief, making pension contributions more tax-efficient than LISA contributions.
• For example, let’s say you pay tax at 40%, you would normally be entitled to tax relief of up to 40% on your personal pension contributions. If you paid £4,000 (net) into a pension, you’d get up to £2,000 in tax relief. However, if you paid the same amount into a Lifetime ISA, you would only get £1,000 in government bonus.

What if you are limited as to how much you can put into your pension?

• Everyone can contribute to their pension up to 100% of their earnings each year or up to the annual allowance of £60,000 (2024/25). As such, the total amount of personal pension contributions, employer contributions, and government tax relief received cannot exceed the annual allowance.
• Should your threshold income exceed £200,000 in a given tax year, you may find that your annual allowance is tapered to less than £60,000. This reduces on a sliding scale.
• Where the income exceeds £360,000, then the annual allowance will just be £10,000!
• Payments in excess of the Tapered Annual Allowance will be subject to an income tax charge.
• For those impacted by the Tapered Annual Allowance, it is possible to carry forward unused allowances from previous years.
• Unused allowances can be carried forward for three years – you must always fund the maximum allowance in the current year first before using unused allowances.
• This gives the opportunity of a larger lump sum contribution, or it is possible to carry on paying higher regular contributions using allowances from the previous year.
• In the position where you are tapered with your pension contributions, an option could be to mix and max between this and a Lifetime ISA whereby you fund both for the tax year.

Has the budget on 30 October 2024 impacted saving into a LISA or SIPP?

• Inheritance Tax (IHT) rules for pensions coming into effect from April 2027.
• CGT rates have increased from 10% to 18% for basic rate and from 20% to 24% for higher tax rate payers, this could affect the overall tax efficiency comparison between pensions and LISAs.

This blog does not constitute financial advice; it is based on the current understanding of legislation, and tax rules can change in the future.

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