Lifetime ISA vs Pension: What Works Best for You?

The earlier we all start to think about our savings, the better. It’s good practice to start thinking about pensions, for example, as soon as you can start working! But what about other tax-friendly ways to help fund your future?

When it comes to choosing between a lifetime ISA vs pension options, the waters can seem a little murky. In this quick guide, I’ll take you through what you need to know about either option, and how they could support your retirement dreams.

Quick summary

If you don’t have the time right now to read the full guide below, no problem – here are the most important points you’ll want to take away.

• A Lifetime ISA (also commonly known as a LISA) is an investment opportunity specifically designed for people under the age of 40. 
• A LISA can help younger people save for retirement or help them become able to buy or invest in properties. 
• LISAs come with the same tax benefits as ISAs, but have additional benefits.
• A pension, meanwhile, is a long-term option for saving money when you eventually retire.
• Most people invest in their pensions for decades before being able to access them. 
• You get immediate income tax relief on the money that is added to your pension each year. ISAs or LISAs do not offer this benefit.
• You can get employer contributions into your pension, depending on where you work. 
• You can also open your own personal pension, or may be allowed a state pension depending on your national insurance contributions.
• LISAs have an annual allowance of £4,000, whereas for pensions it is £40,000.

What is a lifetime ISA? 

A LISA (Lifetime Individual Savings Account) is a type of savings pot that is available to people living in the UK. The idea of a LISA is to help younger people start saving for retirement or for their first home – which is why only people aged 18 to 39 can open one. It’s great because young savers are not forced to choose between saving for a home in one account type or retirement in another account type. The LISA is a great one-stop shop.

Once a LISA’s opened, the user can save up to £4,000 per year in the account up to the age of 50. 

A huge bonus to running LISAs is that the UK government will then add a bonus of 25% on top of everything you save – a maximum of £1,000 per year, if you have managed to save £4,000. The other nice thing is that this £1000 bonus does not count towards your annual £20000 limit for contribution in to an ISA.

Then, the money you save can either pay towards your first home (as long as the value of the home does not surpass (£450,000) – or, you can access the money tax-free once you’ve reached the age of 60. 

The allowed reasons for withdrawing from your LISA tax-free include:

• buying your first home
• aged 60 or over
• terminally ill, with less than 12 months to live

If you try to withdraw the amount for any reason other than these three, you will be charged 25% of the total amount as a withdrawal charge.

There are two types of LISA – you can either choose a stocks and shares LISA, which is better suited to long-term saving plans (such as retirement, for example), or a cash LISA, which better suits short-term savings (such as buying your first home). 

Believe it or not, if you regularly contribute the £4,000 annually, along with the £1,000 bonus received from the government, you could become an ISA millionaire! If you started contributing at age 22, you would be a millionaire by the age of 60 – and that’s just from this one account!

You can try out my UK millionaire calculator with different assumptions to see how fast you can become a millionaire based on your savings rate and growth assumptions.

What is a pension?

A pension is specifically designed as a retirement savings pot. The idea here is that your pension will provide you with an income during your retirement (i.e., when you’re no longer in work). That is why you can only access the money you save in your pension once you have reached retirement age. 

If you work for an employer via PAYE, a percentage of what you earn will automatically be put into your private pension. And, if you are enrolled in a workplace pension scheme, then your employer will also add to the money that enters this savings pot.

You can, of course, open your own personal pension, too, or rely on a state pension. Unless you have a very high income level (beyond £240k), your annual allowance for a private pension is £40,000. There is also a life-time allowance limit of £1,073,100.

Update: The new budget introduced on March 15, 2023 lifts the annual allowance on pensions to £60,000 and removes the lifetime cap. This is a big move. We’re monitoring it and will update the article once everything is confirmed.

A big bonus of contributing to a pension is that you get an immediate relief on your income taxes. If for example your annual salary is £50,000 and you contribute £5,000 to a pension scheme, your income tax will be calculated on only £45,000.

State pensions are available to all people who make national insurance contributions. You’ll typically pay for these contributions via your yearly tax return (if you run a business or are self-employed), or through your monthly PAYE slips.

State pensions can be tricky to manage as the age of retirement in the UK is always changing! Therefore, it’s always a good idea to check your contributions status with HMRC, and to check your prospective retirement age.

Lifetime ISAs vs pensions pros and cons

Now we’ve taken a look at what each of these savings options can do to support your future adventures, let’s quickly break down pros and cons before heading to the final showdown.

Lifetime ISA pros and cons 

Pros: 

• LISAs are fully accessible to younger earners
• The government will add 25% to the amount you contribute (up to £1,000 annually)
• It’s a great way of saving for a future home or your retirement 
• You can save via stocks or cash accounts

Cons: 

• Contributions only available to people between ages of 18 and 40.
• There’s no relief on income taxes while contributing to an ISA.
• There’s a 25% withdrawal charge if you take out money for an unapproved reason

Pensions pros and cons 

Pros: 

• Available to everyone working in the UK
• Contribution to private pensions gets you an immediate income tax relief.
• You’ll benefit from one if you’re paying national insurance
• There are multiple private and investment pension options available
• Your employer can add to your pension in workplace schemes

Cons: 

• Only accessible at retirement
• Pension access ages are always increasing
• The government does not offer a bonus on a pension.

Which is better, a lifetime ISA or a pension? 

If you are trying to decide whether you should contribute to a LISA or a pension, then here’s my suggestion to minimize your income taxes: If you are in the Basic rate (20% tax rate), first top up your LISA up to its full allowance of £4k so you can claim the government bonus (25% return); then add the rest of the money to your pension pot. If however your salary and any bonus push you in to the Higher rate, then only contribute to the LISA what you may need to buy a house. The rest should go in to the pension pot as you get an immediate 40% income tax relief.

Of course there are various factors at play, so please discuss this approach with a financial advisor to ensure that it works for your situation. Both options are great for safeguarding your cash and wealth until you really need it, and let’s face it – you never know when that may be!

LISAs offer a great way of saving money from an early age and planning for a future that will arrive sooner that the government’s suggested retirement age!

What’s more, while LISAs are highly flexible and beneficial in their own right, they are by no means replacements for pensions. You will likely need a pension no matter what, unless you have fantastic liquidity or extensive assets when you come to retire. 

Even if you leave the money in your LISA till you are near your retirement age, you will still be entitled to a pension. The choice is yours!

Check out our guide to the UK state pension if you’d like to know more about how it all works in practice.

Want to Learn More About ISAs?

We’ve covered ISAs in great depth here on PFF and hopefully these articles help you navigate the complicated world of finance and taxes! Here are the list of articles to help you learn more:

1. Best Stocks and Shares ISA for Beginners
2. Junior Cash ISA vs Junior Stocks and Shares ISA
3. Premium Bonds vs ISAs
4. Can I Put £20000 in an ISA Each Year?

If you’re ready to open up an ISA, some of our favourite providers include Plum, InvestEngine, and Moneyfarm. There are many more providers, so if you want to dive in and learn more, you can explore the wide list of ISA providers that we have covered in depth here on the blog.

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