Lifetime ISAs (LISAs) are an attractive option for those saving for their first home.
They offer a 25% bonus on savings up to £4,000 a year. Savers can withdraw their contributions plus the tax-free bonus when purchasing a first home worth up to £450,000 any time from 12 months after opening a LISA.
But how do LISAs compare with pensions for their other intended purpose – retirement planning?
Eligibility, contribution limits, bonus and reliefs
Clients must be at least 18 and under 40 to take out a LISA. The 25% bonus is limited to a maximum of £1,000 a year on contributions capped at £4,000 a year, payable only up to age 50. LISA contributions count towards the £20,000 overall ISA limit for 2017/18 and 2018/19.
There are no minimum age limits to benefit from personal tax relief which is available up to age 75 on pension contributions. Contribution limits can be much higher. The standard annual allowance is £40,000 and carry forward is available. For high earners, the annual allowance may be as low as £10,000. The money purchase annual allowance is £4,000 since 2017/18 – but those affected who’ve accessed flexible pension income are likely to be over the LISA bonus age limit.
Tax relief is available on personal pension contributions at the individual’s highest marginal rates. For basic rate taxpayers, that’s equivalent to the 25% LISA bonus, with greater tax relief on pension savings for higher and additional rate taxpayers.
Investment taxation
Both LISAs and pensions are very tax efficient. Neither is subject to tax on income or gains while invested. And both can provide a wide range of investment options.
Access, penalties and tax on benefits
Apart from first home purchase, penalty-free LISA access isn’t available until age 60. A 25% penalty charge applies to the investment plus bonus if funds are withdrawn earlier. This recovers the government bonus plus a charge equivalent to 6.25% of the investment. Penalty-free access is possible in the event of terminal illness.
Members can’t normally access pension funds until they reach 55 (57 from April 2028). It’s possible to take benefits early if a member is in ill health.
Some savers may see the ability to access LISAs before retirement as an advantage. However, this is only available at a relatively high cost.
LISAs do have a big advantage: there’s no tax on withdrawals if funds remain invested until 60 plus. While 25% of pension funds are usually tax-free, the rest are subject to income tax at marginal rates. Pension freedoms do allow complete flexibility in how and when benefits are taken from minimum retirement age. This can help manage the tax position on withdrawals, but it’s unlikely to match tax-free LISAs.
Employer contributions
LISAs can’t accept employer contributions. Employee contributions made via payroll offer no tax advantages over investing directly from taxed salary.
The big advantage for pensions is that employers have to make minimum pension scheme contributions. Where available, employer contributions, even at automatic enrolment minimum levels, mean workplace pensions should provide far greater benefits (see table 2 below).
Death benefits
Pension death benefits have advantages. Pension benefits are normally outside the member’s inheritance tax (IHT) estate, unlike LISA savings. It’s also possible to pass pension funds down the generations outside anyone’s estate, using tax efficient beneficiary drawdown. LISA allowances can pass to a spouse on death, but there are no wider IHT planning options.
What about the numbers?
Table 1 compares personal contributions into LISAs and pensions assuming a number of tax scenarios. The figures assume no employer contributions and that benefits are taken without charges or penalties. There’s no investment growth for simplicity. As investment tax is neutral, growth assumptions would change the returns but not the percentage differences between scenarios.
Table 1 – Unmatched contributions of £4,000
| LISA | Pension
(basic rate) |
Pension*
(higher rate) |
Pension*
(higher to basic) |
|
| Investment + relief/ bonus | £5,000 | £5,000 | £6,667 | £6,667 |
| Post tax withdrawal | £5,000 | £4,250 | £4,667 | £5,667 |
| Pension v LISA % | -15% | -6.7% | +13.34% | |
| * Assuming net pay method | ||||
From a tax point of view, LISAs produce a 15% better return than unmatched pension contributions for basic rate taxpayers.
They produce slightly higher returns for higher rate taxpayers who remain so when withdrawing funds. But for those who are higher rate taxpayers when making contributions and drop down to basic rate when taking funds, pensions achieve over 13% higher returns than LISAs.
Table 2 looks at basic rate tax paying employees who benefit from employer pension contributions. We’ve assumed the eventual automatic enrolment set two minimum contribution levels of 5% employee and 3% employer.
Table 2 – Employed basic rate taxpayer, £25,000 salary/pensionable earnings, 5% employee and 3% employer contributions
| LISA | Pension with employer contribution | Pension with employer contribution and EE NICs* | |
| Investment + relief/ bonus | £1,250 | £2,000 | £2,150 |
| Post tax withdrawal | £1,250 | £1,700 | £1,827.50 |
| Pension v LISA % | +36% | +46.2% | |
| * Assumes salary sacrifice where 12% of employee contribution NI saving is added for simplicity. Actual levels can be higher. | |||
With employer contributions, pensions produce a 36% higher return than LISAs. If the employee can benefit from salary sacrifice as well, the pension advantage is even greater.
The differential for a higher rate taxpayer will be even greater still.
Bernadette Lewis is financial planning manager at Scottish Widows
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