Lifetime ISA vs pension: which is better for your savings?
George Osborne has unveiled the Lifetime ISA in his latest attempt to get you saving for retirement. But is it actually any better than your traditional pension?
Last week's Budget included the announcement of a new Lifetime ISA (LISA), which will be launched in April 2017.
So how does it work? And how does it compare when it comes to pension saving?
What is a LISA?
Lifetime ISAs (LISAs) allow anyone aged under 40 to save towards their first home or their retirement. But unlike a traditional ISA, the government will add a 25% bonus to any money yet set aside. The bonus is capped at a maximum of £1,000, so you don't get any additional benefit after the first £4,000 you save each tax year.
The money can be kept in cash or put into stock and investment funds like a normal ISA. You can put in a total of £20,000 each year. This is the new annual savings limit for all ISAs, due in April 2017.
Savers can use the pot plus the bonus to put towards the deposit for their first home, up to the value of £450,000. The deal also allows two first-time buyers to pool their resources and buy a home.
Alternatively they can wait until they’re 60 and take the pot plus the bonus tax-free.
Savers have up until the age of 40 to open an account and earn bonuses up to the age of 50. Once you’ve passed 50, you can continue to save, transfer the pot between providers or change investment portfolio.
Find out more about the basics by reading Lifetime ISA: what it is and how it works.
How does it fit around existing pension schemes?
Pension schemes can work independently of LISAs, so you don't have to choose one or the other. Indeed, many financial experts are recommending using both.
But make sure take the time and do your research, as there’s a lot to take into consideration.
Firstly, unlike the LISA, pension schemes will be topped up by your employer, so you can build a bigger pot.
You get tax relief on every contribution to a pension and each one gets an instant top-up, which will start earning compound interest right away. As LISA bonuses are paid at the end of the year, savers don’t get the same benefit.
You can get a pension from the age of 18 and you’ve got a higher maximum contribution to play with.
The annual limit for a pension is £40,000 a year (which is tapered for those who earn more than £150,000). From April 2016, there’ll be a £1 million lifetime limit on pensions covering all of the pensions you have, including ones provided through defined benefits schemes.
As it stands you can get 25% of your pot tax-free on pension savings and the rest is taxed depending on your income tax rate at withdrawal.
Pension savers can now access all of their pot at 55 thanks to the pension freedom reforms, while LISA savers have to wait until they turn 60.
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Who do LISAs really work for?
For pension saving, LISAs work well for the wealthy and the self-employed.
Self-employed people don't enjoy top ups from their employers when they pay into their pension, so if they save through a LISA they aren't actually missing out.
Meanwhile wealthy people who have already maximised their pension tax relief benefits can still get a Lifetime ISA and enjoy an additional tax break. As the lifetime limit on pensions contributions is going to be reduced from £1.25 million to £1 million this year, for savers who think they may hit the limit by the time they reach 40, a LISA could be an effective way to divert their savings and get the maximum tax benefits.
However, higher rate taxpayers could really miss out as they won’t get the tax relief on LISAs that they would with auto-enrolment and other working pensions.
Policy director of Royal London Steve Webb advises savers to take a LISA as a secondary savings vehicle on top of a pension: “With the government bonus being switched off at fifty, the Lifetime ISA starts to look very unsuitable for retirement compared with a workplace pension.
"There is a real danger that the new product will mean that many young people will not start pension saving for their retirement until their thirties or beyond and will struggle to make up for lost time.
“The price of helping young people to buy a house should not be that they have to work until they drop because of inadequate retirement saving.”
If you’re interested in using a Lifetime ISA for your pension, it might be worth reconsidering, particularly if you think there’s a chance that you’ll need to take out funds early.
Are there punitive fees for withdrawing funds early?
Yes. If you want to access your pot early and it’s not for a home, then you’ll be penalised quite heavily. You’ll lose the bonus plus any interest and growth on it, not to mention the 5% early withdrawal charge.
However, the government is looking at other penalty-free reasons to withdraw money, so long as savers replace the cash before they turn 60.
The only exception for early withdrawal penalties is if you fall terminally ill.
Could LISAs lead the way for Pensions ISAs?
Osborne recently ditched his controversial plans to cut the 25% tax relief on pensions.
However, if the Lifetime ISA is successful, it could encourage the government to revisit the issue after the EU referendum, as more savers will eventually be taking their pots and bonuses tax-free anyway. This sneaky tactic has been dubbed ‘the Pension ISA Trojan Horse’.
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