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Lifetime ISA (LISA) vs Pension: Which is better for you?

13–16 minutes to read

Lifetime ISAs are the relatively new kid on the block when it comes to retirement savings options. With the changes to pensions auto-enrollment, nearly every working person has a pension. So why should you consider a LISA? Additionally, could you be missing out on some government bonuses by not having a LISA?

While pensions and Lifetime ISAs are very similar there is some distinct difference that you should consider before ploughing your money into one or the other. Here are some considerations and some great features that not many people are talking about.

What is a Lifetime ISA (LISA)?

A Lifetime ISA is a specific type of ISA that can only be used for two purposes:

  • Buying your first home
  • Saving for later life

As with any ISA, it is a tax-free wrapper, which means any interest or earnings your money makes inside a LISA is free from tax.

Additionally and unlike any other ISA, the government will add 25% of what you do, up to a maximum of £1,000 per year. This is a huge boost for savers.

All ISAs are individual savings wrappers. This means if you are a couple you can both get up to a £1,000 per year bonus.

All of this means that Lifetime ISAs are usually a great fit for those looking to purchase their first home. If you want to read more about buying a home with your Lifetime ISA then check out our Lifetime ISA Guide.

Of course, when considering a Lifetime ISA for later life you need to be aware of the restrictions. Below is a comparison table with the key differences between Pensions and Lifetime ISAs.

Heads up – We aim to produce honest and accurate content, however, we are not financial advisors. If you need financial advice, Unbiased can connect you with a suitable professional for free. Some of our links may earn us a small commission to help us run the site.

Lifetime ISA (LISA) vs Pension - at a glance

Here’s our high-level summary of the differences between Lifetime ISAs and Pensions.

Lifetime ISA Pension
Age Over 18 or under 40. Over 18 (parents can open for under 18s).
Contributions £4,000 (contributions count towards your £20,000 annual ISA allowance).

Can only contribute up to age 50.

£40,000 (Unless you earn over £150,000).

Can contribute until you choose to draw down your pension.

Bonus 25% bonus on contributions up to £1,000 per financial year).

For 20% taxpayers the bonus is equal.

Tax relief based on your earnings (20%,40% or 45%).

For 20% taxpayers the bonus is equal.

Access Over 60 to access without penalty. Over 55 or 57 depending on your age.
Withdrawals No tax to pay on withdrawals if over 60 Subject to standard income tax rules.
Flexibility Can withdraw at any age but will be subject to a 25% deduction Cannot touch until 55 or 57 depending on your age

You can learn more about pensions here – What is a pension and how does it work?

What you need to know about a Lifetime ISA

  • You must be over 18 and under 40 to open a Lifetime ISA.
  • You can put up to £4,000 per year into a Lifetime ISA.
  • The government will add a 25% bonus of up to £1,000 per year.
  • You can put money in up until age 50.
  • Lifetime ISA can be held in cash or stocks and shares.
  • Lifetime ISA is designed to be withdrawn after 60.
  • You can withdraw money before 60 but the Government will take back 25% of the amount withdrawn.
  • Money taken out of a Lifetime ISA is tax-free similar to an ISA (known as a tax wrapper).
  • You can have both an ISA and a Lifetime ISA on the go, but you can only contribute a total of £20,000 per financial year across the two.

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What about tax on a Pension and Lifetime ISA?

Lifetime ISAs, ISAs and pensions are products that can help you reduce how much you pay in tax, either now or in future. It is important to understand the tax on your payslip so you can make effective investment decisions. I know it’s boring but trust me, understanding the basic principles is important if you want to take control of your finances.

If you are a higher rate taxpayer (you earn over £50,271 as of April 2021), whatever you earn above this amount is taxed at 40%.

If you earn under £50,000, then you are taxed at 20%.

To add to the confusion, there is also your National Insurance contributions which are also deducted from your salary. If you are unsure about your take-home pay, we find this a really useful calculator.

This means for every £60 a higher rate tax-payer pays out of their tax home pay into their pension results in a £100 contribution. This is because you get the 40% back that you would have lost to the taxman.

For basic rate taxpayers, you’d have to contribute £80 from your take-home pay to get £100 in your pension. By comparison, if you put £80 into a Lifetime ISA, you’d get a 20% bonus. This results in a £100 total contribution to your Lifetime ISA.

Lifetime ISA vs Pension

A Lifetime ISA is generally considered a less tax-efficient investment versus a pension. Pension contributions can typically be taken as a direct deduction from your salary. This allows you to contribute to a pension directly out of your salary before any Tax and National Insurance are deducted (Gross Salary). This means you’ll get a little bit extra.

Putting money into an investment after you have been paid, usually means you have already paid Tax and National Insurance. While you’ll get the tax back when contributing to a Lifetime ISA or putting your money into a SIPP, you won’t get your National Insurance contributions back.

Therefore, increasing your pension contributions via your employer’s scheme is usually more efficient meaning less of an impact on your take-home pay.

How tax relief works on workplace pensions: If you are a standard rate taxpayer at 20%, for every £100 you earn, you get to keep £80. This is your take-home pay. For every £80 you contribute to a pension (from your takehome pay) the government applies tax relief and so you end up with £100 in your pension. It effectively means you pay no tax on the money you contribute into a pension, you get the Gross amount.

That’s equivalent to a 25% bonus! For higher rate taxpayers at 40%, you only need to put in £60 to get £100 in your pension, meaning a 66% bonus!

You can play with increasing your pension contributions with this calculator. Just go to the pension tab and increase the percentage to see the impact on your take-home pay.

Pensions are nearly always better than a Lifetime ISA

Pensions can have additional benefits depending on what pension scheme is offered by your employer. For example, your employer may match your pension contributions.

This means if you put in 10% of your salary, your employer will also put in 10%. Making a total contribution of 20%. Many employees don’t take full advantage of this lucrative incentive.

As we now know, for a higher rate (40%) taxpayer, a £60 pension contribution will be topped up to £100 via tax relief. The employer then may match this contribution, therefore that £100 will be doubled to £200. Altogether, this is equivalent to a 333% return, instantly.

This is why at the very least, you should consider matching your employer pension contributions. Not doing so means you are missing out on free money.

Some employers may also offer contributions via salary sacrifice, meaning even more money added!

A Lifetime ISA simply can’t match these benefits. However, it does have one huge benefit that pensions can’t match.

Lifetime ISA vs Pension accessibility

One major benefit a Lifetime ISA can offer is accessibility.

You will not be able to access any of your pension money until at least 55, currently. If you are retiring after 2028, this age pushes back to 57.

A Lifetime ISA can be accessed at any time. However, if you access it before age 60, you are going to have to take a 25% haircut.

That’s a significant chunk of your money. It’s also more than the 25% bonus as it’s taken off your total balance and not added to your contribution.

Here’s how the numbers work. If you contributed £8,000 to a Lifetime ISA, the Government would add £2,000 (25%). This leaves you with a pot of £10,000. If you want to withdraw your money, you’ll lose 25% or £2,500. This results in a loss of £500 but unlike a pension, you can still get your cash in an emergency.

But you have to ask yourself; is that worth missing out on those juicy pension benefits that over time, will make a huge difference in the size of the pot of money becomes? Not for most.

If you have maxed out your annual pension contributions (currently £40,000 per year -2020/21) or have hit your Lifetime Pension Allowance (currently just over £1 Million), then a Lifetime ISA can provide an additional tax shelter for your pension monies.

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Lifetime ISA vs a regular ISA

If you are contributing to an ISA, then you are doing so from your take-home pay. Any tax, national insurance and deductions have already been taken out of your salary. Crucially, you do not get that lovely tax relief that you do with pension contributions.

If you were to change your ISA investment to a Lifetime ISA, then you would get 25% added by the Government to each of your contributions.

Remember, these are just tax wrappers. You could use your Lifetime ISA to invest in the stock market or keep it as cash – the same as your ISA.

If you wanted to take money out of your Lifetime ISA, then you are hit by a deduction of 25%. This might feel like you are back to the same place as the ISA but the math doesn’t quite work out like that. In fact, it’s worse – see the example below.

Lifetime ISA - The price of flexibility

Mr ESM puts £4,000 into his Lifetime ISA in year 1 and the Government adds 25%, meaning his pot is now £5,000. He then changes his mind and wants to withdraw the money. £5,000 minus 25% equals £3,750! Mr ESM is upset as he has lost around 6% (or £250) from his initial deposit. This is the price of flexibility.

Yes, it might feel bad to lose some of your initial deposit. This is a way to stash money away for your retirement but also have the flexibility to access that money in an emergency. You don’t get that option with a pension.

You can also make partial withdrawals if you do not need all the money at once but you will lose 25% of anything you take out.

Before opening a Lifetime ISA consider this

  • Higher-rate taxpayers – consider pension top-up first. This will maximise your tax relief resulting in a larger pension pot.
  • Employer pension match – if you’re not getting the full pension match from their employer then consider upping their pension contributions to at least equal the employer match.
  • Nearly 40? – consider opening one to ensure you have one and you don’t fall foul to the age cut off rules. You can open a Lifetime ISA and just deposit £100 giving you peace of mind that it’s there if you need it.
  • Never owned a home – consider a Lifetime ISA to boost your deposit.

Tax implications (and leveraging them)

Withdrawing money from a pension is treated as personal income and taxed accordingly. If you take more than £12,570 (personal tax-free allowance for 2021/2022), you will have to pay Income Tax. The tax you pay will depend on how much you withdraw each year, exactly like PAYE.

A Lifetime ISA is a tax-free wrapper, money withdrawn is not subject to tax. You can withdraw as much as you like from your ISA or Lifetime ISA without paying any income tax. Contributions into ISAs and Lifetime ISAs are seen as already taxed because funds are paid in from net income (income after-tax).

This opens up some interesting options when considering how to minimise the tax you pay at pension age. If you could keep your state and personal pension withdrawals below the income tax threshold and then top up that income with ISA and Lifetime ISA withdrawals you could effectively pay no income tax in retirement!

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Lifetime ISA – the small print

  • You can hold more than one Lifetime ISA but you can only contribute to one or open one per financial year (same as ISAs)
  • You can move to another Lifetime ISA provider at any time
  • All money taken out of a Lifetime ISA after 60 is tax-free
  • You don’t have to take all the money out at once
  • Lifetime ISA savings will affect your ability to claim means-tested benefits (Pensions don’t!).
  • If you are diagnosed as terminally ill, with 12 months left to live, you can withdraw your savings without penalty.

Can Lifetime ISA rules change?

Yes, any current or future Governments can change their mind on any type of ISA, including the Lifetime ISA. They could retire the product which might allow you to migrate your money (and bonuses) to another product or they could stop adding the top-ups.

This is no different from any other Government defined investment like your pension.

ISA rules have changed in the past but in the saver’s favour. Previous changes have increased the allowances allowing you to contribute more each year. Pension rules however have pushed back the access date that retires can access their money. Future pension changes may continue to follow this trend meaning younger savers will have to wait longer to access their pension pots.

Unfortunately, no one knows what will happen in future. The good news is, that here at Eat Sleep Money we aim to bring you the latest updates and remind you when you might need to consider changes. Join our Free UK Personal Finance Club to stay up to date with the latest changes.

What we like about the Lifetime ISA

  • Bonus – a 25% top-up is a huge incentive for savers
  • Flexibility – you can withdraw your cash, unlike a pension. Just be aware that you will be penalised.
  • Tax-Free – like all ISAs, any gains you make will be tax-free.
  • Withdrawals – if you wait till 60 you won’t need to consider paying tax on any withdrawals, unlike a pension.
  • Access – When you hit 60, you can access the full amount. By comparison, a pension needs to be drawn down carefully in order to minimise tax.
  • Lifetime Allowance – If you are close to the Pension Lifetime Allowance then a LISA can still be filled each year ensuring you still get some tax relief.

What we don't like about the Lifetime ISA

  • Withdrawals – any withdrawals before 60 will result in a 25% haircut. It would be nice if the government just took back their stake and not a bit extra.
  • Higher-rate taxpayers – You get the equivalent of 20% tax relief so higher rate taxpayers are financially better off putting money into a pension.
  • Access – You have to wait till 60 to access your cash. Pensions can start to be accessed from 55 (or 57 if you retire after 2028).
  • Allowance – £4,000 out of the £20,000 ISA allowance feels low. By comparison, you can put up to £40,000 into a pension each year (unless you earn over £200,000 per year).

Lifetime ISA (LISA) vs Pension - final thoughts

There’s a lot to consider when deciding how to save for later life. The Lifetime ISA is a no training for those saving for a house. Plus, the rules are pretty clear cut when deciding if you’ll fit the house price criteria. For later life savers, things are a little trickier.

The choice really boils down to flexibility. If you think you might need that money before age 60, then it’s worth considering a Lifetime ISA. However, just beware that you’ll pay a price for that flexibility. You might lose some juicy pension benefits and you will be penalised for access your cash. Of course, you’ll still be able to access it, it won’t be locked away.

As with all personal finance choices, it boils down to your personal situation. I took out a Lifetime ISA as a precaution. As I got closer to 40 I thought I wanted the option to add to it later if I required it. For now, I funnel my cash into my pension however I have the flexibility to adjust that later if required.

Still not sure? We’d love to hear from you. Please join our Free UK Personal Finance Club. You’ll be joined by other like-minded people all hoping to improve their personal financial situation. We’d love to see you there.

Here’s to Financial Fitness

EatSleepMoney.co.uk does not offer financial advice and is intended for reference/information only. Remember, you should always carry out your own research and/or take specific professional advice before choosing any financial products or services or undertaking any business or financial venture. If you need financial advice Unbiased can connect you with a suitable professional for free. Investments may go up as well as down and you may get back less than you put in.