Lifetime ISA or pension: what’s best for your retirement?
In a surprise move, the chancellor announced a new type of ISA in the Budget to help young people buy their first home and save for retirement at the same time.
The Lifetime ISA will be available from 6 April 2017 and will allow under 40s to save up to £4,000 per year where their money will receive a government top up of 25% each tax year. See YourMoney.com’s Lifetime ISA guide for the full information on the scheme.
As it allows you to save for retirement and the government bonus on contributions continues until you reach the age of 50, does the Lifetime ISA beat the current means of saving for a pension?
It depends on a number of factors, such as 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.
Who will benefit most from the Lifetime ISA?
Maike Currie, investment director at Fidelity International, says most people would still be best to use auto-enrolment and benefit from the matching employer contribution.
If you’re in a pension scheme but you’ve secured the maximum employer matched contributions then it will make sense to use the Lifetime ISA over a pension if you’re a basic rate tax payer now and expect to be so in retirement.
It will also benefit basic rate payers now who expect to pay a higher rate of tax in retirement.
She gives the following example: “£800 in a pension attracts £200 tax relief, giving you £1,000. At retirement, £250 is tax free, the rest is taxable giving you a net £850 if you’re a basic rate tax payer – a 6% uplift on your original £800 investment.”
For a higher rate tax payer in retirement, the original £800 investment would actually be worth £700 – a loss of 12.5%.
Comparing this with a Lifetime ISA, £800 would get you the same bonus of £200 but all of it is available tax-free at retirement, giving you £1,000 in total so both a basic rate tax payer and a higher rate tax payer see a gain of 25% on their investment.
“A basic rate taxpayer is 17.6% better off than in a pension while the higher rate tax payer sees nearly a 43% better outcome”, Currie says.
She adds that if you’re a higher rate payer in work then the choice depends on whether you’re a basic rate taxpayer in retirement or a higher rate payer. “If you’re a basic rate payer then you should stick with a pension, if higher rate then a Lifetime ISA is best”.
Tom McPhail, head of retirement policy at Hargreaves Lansdown, adds that anyone paying a lower rate of tax in retirement than in work is likely to find that the higher upfront tax relief on a pension, coupled with the lower income tax on withdrawals “will make a pension more attractive”.
How does LISA stack up against the government’s auto-enrolment scheme?
McPhail says a workplace pension or ISA is likely to be a better option than LISA as “any employer contribution is going to outweigh the benefit of the tax treatment of LISA”.
McPhail gives this example: “Under the auto-enrolment statutory minimum contributions from 2018, an £800 employee contribution would receive £200 in tax relief, plus £600 of employer contributions. Even with income taxed at 20% in retirement, this £1,600 pension pot would produce a net return of £1,360”.
What about for those who don’t receive employer contributions?
McPhail says that for those saving for retirement who won’t get the benefit of an employer pension contribution, LISA could be a good option as £800 paid in will deliver £1,000 plus growth in their hands after the age of 60.
“We think the scheme is likely to be more popular with the self-employed than has been the case with traditional pensions in recent years,”he adds.