Lifetime ISA - saving for retirement?

43% of people we surveyed hadn’t heard of a Lifetime ISA (LISA), and only one in five were confident they knew what it was. For some, a LISA could be the most tax-efficient way to save for retirement.

Let’s take a look at why.

This article isn't personal advice. If you're not sure what's right for your situation, please seek advice. Pension, LISA and tax rules can change, and benefits will depend on your circumstances. Different tax rates and bands apply for Scottish taxpayers.

What is a Lifetime ISA?

Lots of people think a LISA is a way to save for your first home, and it is. But it’s also a flexible way to save for your future.

You can open a LISA if you’re between 18 and 39 years old. You can choose to save cash or invest in the stock market, and as with other ISAs, your money can grow free from UK capital gains and income tax. You’ll even get a 25% bonus, up to £1,000 every year, from the government.

More on Lifetime ISAs

Should I save into a Lifetime ISA or a Pension?

As a general rule, if your employer offers a workplace pension, that should be your first port of call for retirement savings.

This is because, provided you’re eligible, your employer is legally required to contribute an amount equal to at least 3% of your salary, and lots of employers will match anything that you pay into your pension up to a certain limit. You also get tax relief on your pension contributions.

The most any employer will contribute varies, so it’s worth checking this with them. Once your employer is contributing the maximum, then the most tax-efficient account (a LISA or a pension) to pay extra retirement savings into will depend on your personal circumstances – things like your salary, tax situation, and whether your employer offers salary sacrifice and if so whether they agree to pay any National Insurance contribution rebate into your workplace pension.

In the event that your employer does offer this rebate, a pension will be more tax efficient to pay into than a LISA.

If your employer offers salary sacrifice, then a pension and LISA are equally tax efficient. But you might consider a LISA if you’re after more flexibility.

Once money is paid into a pension, it’s locked away for your later years. You’ll usually need to be at least 55 (rising to 57 by 2028) before you can take money out again.

With a LISA you can make withdrawals whenever you like, but there are also withdrawal rules. You’ll usually pay a 25% penalty on withdrawals made before you turn 60 unless it’s for the purchase of your first eligible home.

It’s worth thinking twice before making an early withdrawal from a LISA that’s intended for retirement though. Taking money out could increase the risk of leaving yourself short later on and you could get back less than you put in due to the penalty.

Earn less than £50,270? Here's why you should consider a LISA

For a basic-rate taxpayer, once you’ve maximised the contributions from your employer into your pension, it could be more tax efficient to pay £4,000 of your retirement savings into a LISA. That’s assuming your employer doesn’t offer salary sacrifice.

You get a 25% bonus from the government on money you pay into a LISA up to the £4,000 annual limit – that’s £1,000 in free money each tax year.

When you come to make withdrawals 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). When you take money from a pension usually only up to 25% is tax free, and the rest (75%) is taxable income.

Let's say you pay £4,000 into a LISA for 10 years. You'd have a pot worth £50,000 which you could withdraw entirely tax-free from age 60.

If you pay the same amount into a pension you’d also end up with a pot worth £50,000. That’s because basic-rate tax is currently 20%, and you’d get basic-rate tax relief on contributions, subject to limits. But when you came to take the money out again, you’d only get up to £12,500 tax free, and the rest taxed as income.

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.

Earn £50,270 or more? Here’s why you should consider a pension (or both)

If you’re a higher-rate taxpayer, you’ll usually be better off paying extra retirement savings into a pension because of the extra tax relief you can get on pension contributions will offset the tax you pay on withdrawals later. That's assuming 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. But as a higher earner, you can claim back more in tax relief via your tax return – making pension contributions more tax-efficient than LISA contributions.

Let's say you pay tax at 40%, you’d normally be entitled to tax relief of up to 40% on your pension contributions. If you paid £4,000 into a pension, you’d get up to £2,000 in tax relief. But if you paid the same amount into a LISA, you'd only get £1,000 in government bonus.

If you’re a higher earner, you might be better off with a mix-and-match approach, where you pay into your pension to get all the higher-rate relief you can, and if you max out your pension allowances, you could consider putting the next £4,000 into a LISA.

Tax relief calculator

What if pension tax relief rules change?

Rumours about the fate of pension tax relief are nothing new. But the government’s reply to the tax after coronavirus enquiry and report indicate that they aren’t going to make any sudden moves concerning pension tax relief rules. However, at some point losses from the pandemic will need to be recuperated.

If there was a change, the likely option would be to remove tax relief at your marginal rate, and replace it with a flat rate of relief for everyone. It’s expected this could be somewhere around 25% or 30%.

If it does change to 25%-30% then the LISA will become the most tax-efficient option for the majority of eligible taxpayers as long as LISA rules don't change. But you’ll still need to think about any employer contributions or salary sacrifice first.

LISAs don’t last forever

You can only open a LISA between the ages of 18-39, and can continue to pay into it and get the government bonus until the day before your 50th birthday.

So, if you’re turning 40 this year you might want to put a LISA on your early birthday list.

Using a LISA to save for retirement could offer shelter against any potential pension tax relief changes and access to what could end up being the most tax-efficient way to save for retirement depending on your circumstances.

Even if tax relief rules don’t change, with the HL LISA, there’s no obligation to continuously pay into your account.

MORE ON THE LIFETIME ISA