Lifetime ISA or workplace pension: which is better for retirement saving?
Re-cap of Lifetime ISA
From 6 April, people under 40 will be able to save up to £4,000 a year into the new Lifetime ISA (LISA) and receive a 25% government top up – so up to £1,000 – each tax year.
The new scheme allows you to save for your first home and retirement. The government bonus is paid until you reach 50.
You can withdraw your money at any time before you turn 60, but doing so incurs a penalty charge of 25% on the whole amount. The only exceptions are if you bought your first property under the age of 40 or if you are terminally ill, with less than a year to live.
Currently no cash versions of the LISA are ready on launch day, although Skipton Building Society has confirmed it will launch a LISA in June.
Just three investment platforms are offering a LISA at launch – Hargreaves Lansdown, Nutmeg and The Share Centre.
Re-cap of workplace pensions
Workplace pensions have come under the spotlight in the last few years due to auto-enrolment, first introduced in 2012. The scheme made it compulsory for employers to enrol their staff into a pension scheme. It is being phased in over a six-year period, starting with the largest employers then trickling down to the smallest companies and new firms.
With auto-enrolment, eligible staff (those aged between 22 and State Pension age earning at least £10,000 per year) must be enrolled in a workplace pension scheme but they can opt out. There are currently 7.5 million people enrolled.
The minimum pension contribution under auto-enrolment is currently 1% from the employer and 1% from the employee, meaning a 2% total contribution.
From April 2018, minimum auto-enrolment contributions rise to a total of 5% – 2% from the employer and 3% from the employee. They increase further from April 2019 to 8% – 3% from the employer and 5% from the employee.
If your employer offers a workplace pension outside of auto-enrolment (perhaps you work for a smaller company that has not reached its staging date), you may receive different levels of employer contributions or no contribution at all.
LISA vs workplace pensions
Deciding where to house your retirement savings will depend on a number of factors, including your employment status, the rate of tax you pay during your working life and the rate of tax you expect to pay in retirement, and whether you or your employer contribute to your pension.
Below we look at the pros and cons of a LISA and a pension.
Under auto-enrolment, it is compulsory for employers to offer their staff access to a workplace pension and make minimum contributions.
At the moment, the minimum contribution rate is 1% from the employee and 1% from the employer but it rises from April 2018 (see above).
LISAs are obviously not compulsory and account holders do not receive any contributions from their employer.
Steven Cameron, pensions director at Aegon UK, says: “With a LISA, you do not get an employer contribution. So £1,000 on the way in pays £1,250 on the way out. This is likely to be far less than a workplace pension with employer contribution.”
Tax relief vs government bonus
With workplace pensions, employees receive tax relief as well as employer contributions. Taking a basic rate taxpayer, with every £800 invested, the government adds £200 to make a total of £1,000 in the pension scheme.
Higher rate taxpayers receive a greater uplift from tax relief. If they pay in £800, the government adds £200 and they can also claim a further £200 from their self-assessment tax return meaning a higher rate taxpayer only needs to put in £600 to get £1,000 in their pension.
A basic rate taxpayer saving into a pension gets 20% tax relief and the LISA bonus is expressed as a percentage of what you put in. However, Richard Parkin, head of pensions policy at Fidelity International explains that the 20% tax relief is actually the same as the 25% LISA bonus.
Parkin says: “Putting £800 in a LISA gets a 25% bonus which gives £200 meaning there’s £1,000 in the LISA.
“The pension tax relief is 20% of the gross contribution (£1,000) while the LISA bonus is 25% of the net contribution (£800). Both end up with £1,000 invested but of course the pension is taxable when benefits are taken while the LISA benefit is tax-free.”
On the face of it, for a higher rate taxpayer, it seems the tax relief and employer contributions are far more generous than the 25% uplift under the LISA. But savers also need to consider what rate of tax they expect to pay in retirement.
Tax on pension income
Savers need to be aware of the implications when they’re ready to withdraw their money. The key consideration is what rate of tax they’re paying now and what rate of tax they’ll pay once drawing on the pension money.
With a pension, the first 25% can be taken out tax-free (under pension freedoms) but the remainder will be taxed at your marginal tax rate.
With a LISA, there is no tax on the way out as long as you make no withdrawals before the age of 60.
Parkin gives some examples below, based on £800 to invest:
1) Basic rate taxpayer in work and retirement (better off in LISA)
£800 in a pension gets £200 relief giving £1,000 in the pot. The first £250 is tax-free (25% of total) and the rest (£750) is taxed at 20% giving £600 net and £850 altogether. This is a return of £50 on the original investment of £800, or 6.25%, much less than the LISA 25% bonus.
2) Higher rate taxpayer in work and retirement (better off in LISA)
Parkin says savers will need to put in more than £800 as the tax man will give a refund as well as basic rate tax relief.
He explains £1,066.67 in a pension attracts 20% relief of £266.67 giving £1,333 in a pension. However, they also get £266.67 back from the tax man meaning the saver’s contribution only really costs £800.
“When I take my pension benefits this comes out as £333.33 tax-free (25% of total) and the rest (£1,000) taxed at 40% giving £600 net and £933.33 altogether. This is a return of £133.33 on my original investment of £800, or 16.7%.
“As above, £800 in a LISA gets a £200 bonus giving me £1,000 which I can take out tax-free giving me £1,000 or a gain of £200 on my original £800 investment, a return of 25%. So I’m better off in the Lifetime ISA to the tune of £66.67 or 8.3%.”
3) Higher rate tax payer in work but basic rate payer in retirement (better off in pension)
As above a contribution of £800 actually gets £1,066.67 in a pension and attracts 20% relief of £266.67 giving £1,333 in a pension. But the saver also get £266.67 back from the tax man meaning the contribution only really costs £800.
Parkin says: “When I take my pension benefits this comes out as £333.33 tax-free (25% of total) and the rest (£1,000) is now taxed at only 20% giving £800 net and £1,133.33 altogether. This is a return of £333.33 on my original investment of £800, or 41.7%. The LISA again delivers me a gain of £200 on my £800 investment, a return of 25% so I’m better off in the pension than the LISA to the tune of £133.33 or 16.7%.”
People not in a pension scheme and self-employed
One of the main positives of the workplace pension is that people who might not normally join a pension scheme at the earliest opportunity, will automatically be signed up.
“This gives them the platform to build a more financially comfortable retirement,” says Danny Cox, chartered financial planner at Hargreaves Lansdown.
“The downside is that the contributions aren’t likely to be sufficient to produce a stellar income in later life and individuals will need to save and invest more, much more, to be able to enjoy the retirement they hope to lead.”
The self-employed don’t benefit from auto-enrolment and there is no ‘employer’ to add contributions. So for them, the LISA will offer an attractive alternative to current personal pensions.
Considering opting out of auto-enrolment in favour of the LISA?
Depending on your firm’s auto-enrolment staging date, you have a one-off chance to ‘opt out’ at commencement. But you can stop contributing any time you choose. Those who opt out are re-enrolled every three years and have to opt out again if they still don’t want to join.
Cox says that the employer contribution is usually more valuable than the tax relief or bonus under a LISA. “As a general rule, a pension should be the first port of call for retirement planning.” He adds that for anyone considering opting-out of auto-enrolment towards a LISA shouldn’t do so as for the vast majority of people this is a bad idea.
Cameron says: “Despite LISA being positioned as the solution to multiple savings objectives, for most people, it makes sense to have a range of different savings vehicles – a workplace pension, an ISA or bank account for ‘rainy day’ money and for future first time homeowners a Help to Buy or Lifetime ISA.”