Isa or pension: what’s best for retirement?

Savings scheme can help you grow a nest egg, but is it all it’s cracked up to be, asks Danielle Richardson

‘A pension can be more lucrative, thanks to the tax relief paid on money put into it’

Lifetime Isas were first introduced in April 2017 as then-chancellor George Osborne’s offering to help first-time buyers and future retirees grow a tax-free nest egg in one fell swoop.

Savers aged 18-39 are able to open a lifetime Isa (or Lisa), where money can be held as cash, or invested in stocks and shares. You can deposit up to £4,000 in each tax year – what you pay in will come out of your £20,000 Isa allowance – and the big incentive is the Government adds a 25pc bonus up to a maximum £1,000 a year.

You can carry on saving money until you turn 50. Money can only be withdrawn to buy your first home or to use in retirement after the age of 60. Taking money out for any other reason (other than being diagnosed with a terminal illness) will trigger a withdrawal penalty, which not only removes the Government bonus, but some of your own cash, too.

Cash Lisas work in the same way as other cash Isas; you’ll earn a variable rate of interest, which will remain tax-free while it’s held within an Isa.

Some investment Lisas, such those offered by Nutmeg and Moneybox, have the option to put your money into a ready-made portfolio. Given there’s more input from the provider, these can come with more fees. Nutmeg fees, for example, are 0.75pc up to £100,000, with 0.35pc on anything over. If you prefer a more DIY approach, providers such as AJ Bell and Hargreaves Lansdown give you the flexibility to choose for yourself.

Lifetime Isa or pension?

Given the cost of retirement is on the rise, a Lisa can offer a way to save for when you’re over the age of 60. It could be used as well as, or instead of, a private pension, but there are key differences.

Opening the account

Parents can open pensions for their children, and other people – such as grandparents – can pay into the account. Lisas can only be opened by the saver, and they’re also the only ones who can make deposits.

When you’ll pay tax

The money you pay into a Lisa will have already been taxed (unless you’re not a taxpayer). While money is held within the Lisa, any growth will be free from tax. Tax benefits for pension savings come when you pay in the money, thanks to pension tax relief. But the funds become taxable when you draw down the money.

‘Free’ money

For each £1 you pay into a Lisa, you’ll get 25p “free” from the government. That’s in addition to savings interest or investment growth. A pension can be more lucrative, thanks to the tax relief paid on contributions – this is based on the highest rate of income tax you pay, meaning basic-rate taxpayers get 20pc tax relief and those who pay higher-rate tax get 40pc. It means saving £100 only costs £80 as a basic-rate taxpayer, but for a higher-rate earner it would cost £60. For a basic-rate taxpayer the “free” money is the same in a Lisa or a pension. But once you become a higher or top-rate taxpayer, a pension wins out.

Employees will benefit even more. Under auto-enrolment rules, employers must contribute at least 3pc to employees’ pensions – many will pay in more and match, or even exceed, your contribution. What’s more, if you pay in through a salary sacrifice scheme, you’ll also get National Insurance relief, plus income tax relief.

Deposit restrictions

The most that will be paid into your Lisa each year is £5,000, made up of £4,000 from you and £1,000 in government bonuses. At most, this can be paid in each year between the ages of 18 and 49, meaning up to £155,000 can be deposited in total. This is not including savings interest or investment growth, which will continue to accumulate. While this is not an insignificant amount, it’s nothing compared with what you could save with a pension. While you’re still working, and before any withdrawals have been made, you can pay in up to £60,000 a year, or up to 100pc of your annual salary – whichever is less.

Access age

Your Lisa savings can be accessed any time after you turn 60. You can make partial withdrawals, or withdraw it all – although it will fail to be tax-free if you then pay it into a different account. You’ll need to wait until you reach retirement age to access your pension savings, which is 66. Under pension freedom rules, you can access defined contribution pension savings at age 55 (increasing to 57 in April 2028).

Liable for inheritance tax

Lisa savings form part of your estate, and therefore come within the scope of inheritance tax. Pension savings, however, are not considered as being part of someone’s estate, so it can be a more tax-efficient option for your heirs.