I wanted to pick your brain about the pros and cons of a Life Isa versus a personal pension.
To give you some context I recently moved an old private company pension pot into a personal money box to have more control over my investments.
I also transferred money into a Lifetime Isa that I wanted to open before I turned 40 to hedge my bets so to speak.
I have a stocks and shares Isa and I have separate stocks and shares accounts. I also pay the maximum I can into my employer’s pension scheme.
Decision: Our reader is wondering whether to save more in his Life Isa or pension
My question is; Do I pay more money into my Life Isa over the next 13 years (until age 50) so I can get it at 60 tax free when I withdraw, or keep paying more into my personal pension in the hope that the money will compound over time. ?
Obviously, I will be paying 20% tax on the back end with this income so wondering if the non-volatile LLitime Isa option would be more beneficial?
I know there are pros and cons to both so I wanted to get your input. I also own my own home so I won’t need to use a Lifetime Isa for this, but it could be a great way to save for my child’s future. Any advice would be most welcome.
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Steve Webb replies: When the Lifetime Isa was launched it had a dual purpose – to help first-time buyers build savings and to enable people to save for their retirement.
In your case it is the long-term role of the Isa in providing funds for the future that is most beneficial to you.
As you have specifically asked about the tax differences between saving in a Life Isa and saving for a pension, I will focus my answer on that.
But, as a reminder to other readers, other things to consider when comparing an Isa versus a pension would be:
– Your employer must pay a minimum amount into your pension and may pay more if you contribute more; this is a huge advantage of pensions over Isas/Lifetime Isas;
– Different types of products have different charges; most workplace pensions have very low payouts, especially if you work for a large company, so a workplace pension can be a cheaper investment vehicle than a stocks and shares Life Isa/Isa;
– Accessibility – currently you can get money from the pension fund from the age of 55, although this will rise to 57 in 2028, and may increase further; money in a Life Isa is locked in until you’re 60 (unless you’re willing to pay a penalty).
In terms of the tax treatment of Life Isas and pensions, the main differences are:
– With a Life Isa, you contribute from your take-home pay but the Government gives you an increase; for every £4 you put in (up to a maximum contribution of £4,000 per year), the Government will match £1 (ie a maximum of £1,000); there is no tax on investments in your Life Isa, and any withdrawals after age sixty are completely tax-free;
– For pensions, you get tax relief on your contributions up to an annual allowance of £40,000 (for most people); the higher your tax rate, the more tax relief you get on pension contributions; money in the pension grows tax-free; when you come to collect your money, a quarter can be taken tax-free and the rest is taxed when you withdraw it, along with your other income. There is also a lifetime allowance which covers the amount of pension you can add while still enjoying tax relief.
If we only consider the tax differences between the two, the balance between the Lisa and the pension depends on whether you pay tax at the basic or higher rate while working, and also on your tax position when you retire.
To keep things simple, we’ll assume for now that investment growth and costs are the same whether they’re in a stocks and shares Life Isa or a pension, and that no further employer contributions are available to the pension.
We also assume that you have no Annuity or Life Allowance issues.
An easy way to see the differences is to look at two people who each have the option of paying into a Life Isa or pension, one of whom is currently paying tax at the basic rate and the other is paying tax at the higher rate.
Basic rate of taxpayers
If we start with the basic taxpayer, let’s say they contribute £80 into a Life Isa.
The Government will increase this to £100. Ignoring investment income and payments, this would be £100 in retirement that can be taken tax-free. So someone taking out a Lifetime Isa starts with £80 and ends up with £100.
Now assume that a basic rate taxpayer pays instead a pension, and is also a basic rate taxpayer when he retires.
If a worker pays £80 into their pension from their post tax income, the government will add this to basic tax relief to give £100 in pension. At retirement, a quarter (£25) can be taken tax-free, but 20% tax will be charged on the remaining £75. This is £15 in tax, leaving £85 after tax.
In this simple example, both people put £80 into their products but the person with Lisa ends up with £100 in retirement while the person with the pension ends up with £85. Both are good investments, but if you just look at the tax, the Life Isa looks better.
Maximum rate of taxpayers
Consider now someone who is a top rate taxpayer at work but a basic rate taxpayer when they retire.
The Lifetime Isa investment calculation is the same as before. They keep £80 of their taxable income, it is increased by the Government to £100 and they can withdraw $100 for free in retirement.
But for pensions it is different. When an employee pays £80 from their take-home pay into the pension, they still get a £20 top-up from HMRC.
But they can claim another £20 in higher rate tax relief through their tax return. This means it has cost them £60 in take-home pay to get a £100 pension pot.
At retirement, a quarter is taken tax-free, and the rest is taxed at the basic rate, again leaving them with £85.
In this case, the pension saver has a better plan. A Lifetime Isa saver spent £80 to get £100 in retirement, an increase of 25 per cent. But a pension saver spent £60 to get £85 – an increase of more than 41 per cent.
STEVE WEBB ANSWERS YOUR PENSION QUESTIONS
In summary, if you ignore the other differences and just look at the tax treatment, a Lifetime Isa will look better to a basic rate taxpayer than a pension, but a pension will look better if you’re a higher rate taxpayer when you’re in work, as long as you’re a standard rate taxpayer. basis at retirement.
Note that the models assume income tax rates stay the same. If rates are lower when the money is withdrawn, that can direct more balances towards pension outcomes.
One final thought about investment returns.
Basically, stocks and shares LLitime Isas and pensions can be invested in the same type of investment, so unless there is a big difference in the costs of the products or the types of funds available, it may not make a big difference which you choose as your vehicle. investment.
However, you mentioned the ‘low volatility’ Lifetime Isa option which makes me wonder if you have a Lifetime cash Isa? If so, this is unlikely to be a good idea in the long run.
If you are currently under the age of 40 and won’t touch the money until you are in your sixties, this means locking your money into an account that offers a very low interest rate, and one that is well below the rate of inflation. You guarantee the loss of real terms year after year.
While there is a role for a cash Lifetime Isa for short-term savings purposes, they are not very suitable in many cases for long-term savings.
If you compare a cash Lifetime Isa with a workplace pension, and look over several decades, the higher investment returns in the underlying workplace pension fund are more likely to offset the tax benefits of your Lifetime Isa money.
Ask Steve Webb a pension question
Former Pensions Minister Steve Webb is This is Uncle Money.
He’s ready to answer your questions, whether you’re still saving, in the process of retiring, or worrying about your finances in retirement.
Steve left the Department for Work and Pensions after the May 2015 election. He is now a partner in the specialist consultancy firm Lane Clark & Peacock.
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