Should a client under the age of 40 invest in a pension or a Lifetime Isa? This is a new issue thousands of advisers will be considering.
From April next year, any adult under 40 will be able to open a Lifetime Isa. Investors can save up to £4,000 each year and will receive a 25 per cent bonus from the Government on this money. The bonus will only apply to contributions made before aged 50, however.
Money put into a Lifetime Isa can either be kept there until the investor is over 60, when it can used for retirement income or capital, or can be withdrawn to help buy a first home up to the value of £450,000. In both instances, the investor retains any bonuses and growth on them. Investors will be able to access funds early but such withdrawals will involve the loss of the government subsidy. An employer will not be able to make contributions to an employee’s Lifetime Isa.
So let’s compare the two products as far we can at this stage. The Lifetime Isa effectively qualifies for the equivalent of 20 per cent tax relief but, unlike the pension, the investor can draw the benefits wholly tax-free. For a basic rate taxpayer, that puts the Lifetime Isa ahead. And for a person who is a basic rate taxpayer when they contribute but expects to be a higher rate taxpayer when they draw the benefits, it puts it well ahead of the pension contribution.
The Institute for Fiscal Studies has produced a useful chart comparing the tax efficiency of the Lifetime Isa and pension contributions and benefits at different tax rates (see below).
The first column – an Isa investment – is the benchmark: no tax on the input and none on the output. The other columns show the contribution needed to match the £100 saved in an Isa from a Lifetime Isa and from pension contributions in different tax circumstances.
The 20 per cent effective tax relief on the Lifetime Isa means the net cost to achieve the £100 outcome from the ordinary Isa is just £80. That is much better than the pension contribution made by basic rate taxpayers, who get 20 per cent tax relief on their contribution and pay basic rate tax on the taxable part of their pension benefits (“basic, basic”).
The Lifetime Isa is also slightly better than the pension contribution of a higher rate taxpayer who then pays higher rate tax on their benefits (“higher, higher”).
But the pension contribution is more attractive than the Lifetime Isa for the investor who gets higher rate relief on their contribution but pays basic rate tax on their benefits (“higher, basic”).
And it is a draw between the Lifetime Isa and the pension if the investor gets basic rate tax relief on the contributions but pays no tax on the benefits (“basic, zero”).
Everything is further skewed in the direction of the pension where the contributions are made by an employer (for example, by salary sacrifice) and the National Insurance contribution saving is effectively invested in the pension.
Contribution required to match £100 saved in Isa: By marginal tax rate in work and in retirement
- Employer pension contributions still more generously treated
- Can gradually shift money from Lifetime Isa to pension from age 60 (Benefit from Lifetime Isa top-up and pension tax-free lump sum)
Source: Institute for Fiscal Studies
But of course it is not just a question of the arithmetic of tax on the contributions and outputs. There are also issues of early access. There is a real attraction in being able to use the Lifetime Isa funds without penalty to help fund the purchase of a first home.
The Government is mooting the idea of access before age 60 but with a loss of some of the benefits. This could be an attraction but the temptation could lead to some expensive mistakes. The inaccessibility of pensions has some advantages because of its paternalistic protection features.
The pension is slightly better than the Lifetime Isa in a few minor respects that probably will not make a difference to the decision one way or the other. The government top-up to the Lifetime Isa will take place at the end of the contribution year – almost certainly later than the tax relief due under pension relief at source will kick in.
What is more, the death benefits will be inside the Lifetime Isa holder’s taxable estate – unlike a pension – unless the underlying investments are qualifying Aim shares.
Another point is an investor will not be able to access their Lifetime Isa penalty-free until age 60 rather than their state pension age as they can with a pension. But none of these issues are likely to be a major factor for most people choosing between making a Lifetime Isa or pension contribution.
The new product will spring into action in 2017/18, the same year as the Isa allowance rises to £20,000, and the Lifetime Isa investment will count towards this. Isas look as if they will become central to retirement planning for most clients, especially as the annual and lifetime allowances drop. Lifetime Isas, in particular, will be very attractive for all investors, especially basic rate taxpayers. But pensions will still be attractive, especially where employers are contributing.
Danby Bloch is chairman at Helm Godfrey