Should I use a Lifetime ISA or a pension? 

How Lifetime ISAs work  

The rules around Lifetime ISAs (LISA) are a little more complicated than the other types of ISA, so understanding the rules and potential penalties is important for anyone weighing up whether a pension or LISA is better for them.  

You’re able to open a LISA if you’re aged 18 to 39 and resident in the UK or a crown servant. Any contributions you make to your LISA, up to the annual allowance of £4,000, will benefit from a 25% government bonus, which is paid when you contribute. Your contributions and the government bonus both earn tax-free interest, if you’ve opened a cash LISA, or tax-free returns, if you’ve opened a stocks and shares LISA. You can continue paying into a LISA until your 50th birthday.

You can access the money in your Lifetime ISA to buy your first home worth less than £450,000 or less, once you’re 60, or if you’re terminally ill. If you need to use it for something else, you’ll have to pay a government withdrawal charge. The withdrawal charge is usually 25%, which means you will get back less than you put in – but it has been temporarily reduced from to 20% for withdrawals from 6 March 2020 till 5 April 2021 due to coronavirus.

The Lifetime ISA versus the pension 

If you open a Lifetime ISA at 18 and make the maximum contribution each year, there’s a potential £32,000 in government bonuses available. So, if you’re looking to build a significant pot to support you in later life, are you better off with a LISA or a pension? 

Unfortunately, the simple answer is there’s no simple answer. Both pensions and Lifetime ISAs have their advantages and disadvantages and whether a LISA works for you as a part of your retirement planning will depend on several factors.  

Tax  

Lifetime ISAs and pensions are taxed differently. A pension is tax-free when you pay into it, thanks to tax relief on the whole contribution, but you’re taxed on the money you withdraw from it at your marginal rate of tax at the time you’re withdrawing.  

A Lifetime ISA is the other way around: you contribute money you’ve already paid tax on, but eligible withdrawals are tax-free. 

Government top-ups  

Pension contributions are eligible for government top-ups known as tax relief. The rate at which this is applied depends on your income tax rate: basic rate taxpayers receive 20% tax relief from HMRC. If you have a relief-at-source pension, such as the one offered by Nutmeg, your tax relief is claimed for you. If you’re a higher rate taxpayer, you get 40% tax relief in your pension contributions and additional rate taxpayers get 45%, claimed through tax-relief.  

Contributions to a Lifetime ISA receive a government top-up of 25% up to a maximum of £1,000 per tax year.  

Allowances  

When it comes to how much can be contributed within a single tax year, there is the potential to put considerably more into a pension than a Lifetime ISA. For most people, the annual allowance for their pension is 100% of their salary or £40,000, whichever is lower.  

The maximum amount that can be contributed to a Lifetime ISA in a single tax year is currently £4,000. This £4,000 is part of your overall £20,000 annual ISA allowance – so if you contribute £4,000 to a LISA, you have a remaining £16,000 to contribute to ISAs of other types.  

Contributions from others  

If you’re employed, you may receive employer-matched contributions towards your workplace pension.  

For Lifetime ISAs, only the account holder can open and manage their LISA. While you can be gifted money to pay into your LISA, LISAs cannot accept employer contributions directly.  

If you’re self-employed, you won’t benefit from employer-matched contributions, so a Lifetime ISA – and the 25% government bonus – may win over a stakeholder pension or personal pension. 

Flexibility  

If you’re unsure of your goal, the Lifetime ISA offers more flexibility than a pension: you can use it to save towards buying your first home, retirement, or both. A pension is only for retirement. 

Accessing your money  

If you need to access your money before you’re 60, you may be better off with a pension because you can access your money once you’re 55, set to rise to 57 in 2028. With a Lifetime ISA, you have to wait until you’re 60, unless you’re buying your first home or terminally ill, to withdraw your money without paying a penalty. 

If you need to access your money ‘early’ (and not because of a critical illness), and you’re willing to pay a penalty, the Lifetime ISA wins. Aside from special circumstances, pensions don’t allow early withdrawals.  

If you think you will need to access your money before you’re either 55 or 60, then a normal ISA might be better for you. This is a tax-efficient way of putting money away for your future and there’s usually no penalty to withdraw.  

And the winner is… 

As a rule of thumb, if you’re employed, then continue to pay into your workplace pension and reap the benefits of any employer-matched contributions. These contributions plus the tax relief are likely to outweigh the Lifetime ISA 25% government bonus. 

If you’ve maxed out annual contributions on your workplace pension or you think you’re likely to reach the lifetime allowance for your pension, and you want to save or invest more, the Lifetime ISA could be a good option. This will provide additional tax-free income for you in later life, but it’s important to remember you can’t access the money in your LISA until you turn 60.  

If you’re self-employed, your tax status and personal situation will come into play to work out which is a better option for you. Self-employed higher rate taxpayers will benefit more from paying into a pension (the tax relief wins over the Lifetime ISA bonus). It’s not as clear cut for self-employed basic rate taxpayers though, and it’ll be about working out which scheme works for you. 

As we said, there’s no simple answer to the question which is better – the pension or the Lifetime ISA. It’s perhaps timely to remember that, the Lifetime ISA was introduced to complement pension investments, rather than to replace them.  

Risk warning 

As with all investing, your capital is at risk. A pension may not be right for everyone and tax rules may change in the future. If you are unsure if a pension is right for you, please seek financial advice. 

A Lifetime ISA may not be right for everyone. You must be 18–39 years old to open a Lifetime ISA. If you need to withdraw the money before you’re 60, and it’s not for the purchase of a first home up to £450,000, or a terminal illness, you’ll pay a 25% government penalty (the withdrawal penalty will be temporarily reduced from 25% to 20% from 6 March 2020 till 5 April 2021 due to coronavirus). So, you may get back less than you put in. 

If you choose to opt out of your workplace pension to pay into a Lifetime ISA, you will lose the benefits of the employer-matched contributions. 

If you are unsure if a Lifetime ISA or pension is the right choice for you, please seek financial advice.