As we near the third anniversary of the Lifetime ISA being launched, and the end of the tax year, many people will be wondering whether they should be using a pension or a Lifetime ISA to save for retirement. It depends on your circumstances as we now explain.

THE BASICS

Lifetime ISA

You can save up to £4,000 a year into a Lifetime ISA, with the Government adding 25% to anything you put in up to the age of 50, meaning a maximum of £1,000 free Government money each year. After 50 you can keep adding to the account but you won’t get the Government top-up.

To open one you need to be aged between 18 and 39, and anything you put in counts towards your £20,000 annual  ISA allowance.

The only way you can withdraw money without a penalty charge is if you are buying your first property (subject to certain restrictions), you’ve reached age 60 or you are terminally ill. Any other reason for withdrawal will be subject to a 25% penalty, taken off your withdrawal amount.

Like a normal ISA, any money in the account grows free of tax and when you take out the money you pay no income or capital gains tax on any withdrawals.

Pension

Most people can contribute up to £40,000 a year into a pension, as long as this doesn’t exceed their annual salary. There are some lower limits for very high earners and those who have already accessed their pension, but that only affects a small group of people.

The amount of Government boost you get to your pension depends on your rate of income tax. Everyone gets 20% relief on their contributions, but if you’re a higher earner you can claim additional tax relief through your tax return.

The money is locked up until you reach the age of 55. At this point 25% of any withdrawals will be tax free, while the rest will be taxed at the income tax rate you pay at the time.

WHICH IS BETTER FOR YOU?

A lot of the answer to this question depends on your personal financial circumstances, but there are some general rules of thumb you can follow.

Basic rate taxpayers

If you’re a basic rate taxpayer, you might find the Lifetime ISA a potentially attractive retirement saving option. You’ll receive the same bonus as a pension on contributions up to the £4,000 annual limit, while withdrawals are completely free of tax once you reach your 60th birthday.

Pensions, on the other hand, generally can’t be touched until you reach age 55 and only 25% of the fund would be free of income tax.

What’s more, while you will pay an exit penalty if you want to get your money out of the Lifetime ISA, at least you have the ability to access it should you hit hard times and need cash – which is not the case with your pension if you’re younger than 55.

Age is a key factor. If you’re already 40 or older then you can’t open a Lifetime ISA account. And the Government won’t give you that 25% top-up after age 50, so at that point you might be better switching to a pension.

Looking at the numbers, someone who pays in £4,000 a year from age 18 to 50 into either a Lifetime ISA or a SIPP (self-invested personal pension) will receive exactly the same amount of Government bonus (£32,000). If we assume 4% annual investment growth after charges, both will have built a fund worth £326,000.

Based on today’s tax rates, someone who took an ad-hoc lump sum of £20,000 from their pension at age 60 would pay £500 in tax (assuming they had no other taxable earnings).

This is calculated as follows: 25% is tax free, so £5,000. The individual then has £12,500 personal allowance which is the amount of income they don’t have to pay tax on. From the £20,000 pot, £17,500 is therefore tax free. Of the remaining £2,500, the basic rate taxpayer would pay 20% which is £500.

The same investor would pay no tax at all on their Lifetime ISA withdrawals.

The difference in tax paid expands as the withdrawals get bigger. If the entire fund was withdrawn at once – not an advisable retirement strategy in most cases – the pension investor would pay a whopping £95,025 in income tax.

This is calculated as follows: 25% of the £326,000 pot can be withdrawn tax free, equal to £81,500. On the remaining £244,500, the individual wouldn’t get a personal allowance because their income is over £125,000. They would have to pay a mix of 20%, 40% and 45% tax at the different income brackets.

High earners

The way pension tax relief works means higher and additional-rate taxpayers should almost certainly use their pension as their main retirement savings option. As well as getting 20% tax relief (equivalent to a 25% Government bonus), the same as offered by a Lifetime ISA, higher rate taxpayers can claim an extra 20% through their tax return, while additional rate taxpayers can claim 25%.

So if an additional rate taxpayer paid £80 into a pension, an extra £20 would be added to it by HMRC and then they could claim back a further £25 directly from the taxman. This means it has cost them just £55 to get £100 in their pension, equating to a staggering 82% savings bonus.

People with an employer pension

The golden rule is if you’re going to get some form of contribution from your employer into your pension you should exhaust that first, as it’s effectively free money that you wouldn’t get if you open a Lifetime ISA and put your contributions into that wrapper.

This contribution from the employer is basically like a pay rise and the bonus from the Lifetime ISA won’t match it – this is true even if you’re a basic rate taxpayer.

However, if you want to contribute more to your retirement savings than your employer will match you could use a Lifetime ISA. For example, if your employer matches up to 5% of your pension contributions but you want to put 7% of your salary away you could put 5% into your workplace pension and get employer matching and put the rest in your Lifetime ISA assuming it didn’t exceed the £4,000 annual contribution limit.

High earners and those with big pension pots

People who earn over a certain level will see the amount they are able to contribute to their pension each year reduced. The exact rules are tricky, so read more here.

It means that if they’ve maxed out their annual pension contributions they could use a Lifetime ISA to bolster their retirement savings, as everyone qualifying for the wrapper gets the £4,000 annual Lifetime ISA limit – regardless of their earnings.

This is also an option for those people who have reached their pension lifetime allowance, which is £1,073,100 from 6 April. Individuals who still have spare cash to put away could use a Lifetime ISA to carry on saving for retirement.

Bear in mind that to use this option you’d have to be under the age of 40. You could open a Lifetime ISA now and use it later on.

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