The new Lifetime ISA has created more choice when saving for retirement. Rather than act as a pension replacement, the new Lifetime ISA will offer additional tax relieved savings for young savers – to save for their first home or as a top up to their pension saving.

But there’s a danger that some of the headlines may influence some young savers to opt out of their employer’s workplace pension and miss out on free money from their employer – a costly mistake, as can be seen in the numbers below.

  • When looking at the actual rates of tax paid in retirement, pensions should remain the first choice for the majority of people saving for retirement.
  • The additional benefit provided by employer contributions puts pension ahead of other savings wrappers.
  • Young people will have a better incentivised way of saving for a deposit on their first home.
  • The under 40s will have the potential for up to £45k of tax relievable retirement saving each year.
  • Even those with no earnings can now enjoy tax relief on £8,600 a year (£3,600 in their pension and £5,000 in a LISA).
Lifetime ISA

The LISA provides all the familiar ISA benefits, such as tax free investment growth and tax free withdrawals, but with the added benefit of a Government top up of £1 for every £4 saved. And penalty free access before age 60 where the funds are used for a deposit on first homes.

With a 25% Government bonus and no tax on withdrawal after age 60, it’s an attractive proposition for all taxpayers. On first inspection it would appear to provide a better return than the current pension tax relief system.

The following tables show the position for savers after taxes are deducted but igoring investment growth and charges.

Savings vehicle Tax relief / Saver’s bonus  Tax rate paid on income Pay  Pot Get back Gain
Pension 67%
(40% relief)
40% £100 £167 £117* 17%
Pension 25%
(20% relief)
20% £100 £125 £106* 6%
LISA 25% 0% £100 £125 £125 25%

* Assumes 25% tax free cash taken.

Headline rates can be misleading and only give half the story

In reality higher rate taxpayers don’t pay 40% tax on their income. In fact, the most any higher rate taxpayer (on incomes up to £100,000) with a full personal allowance will ever pay is 29% – and that’s ignoring tax free cash.

This is because we have an income tax system which works in bands, so we don’t pay a fixed rate of tax on all our income.

We might refer to someone earning £50,000 as a 40% or higher rate taxpayer. But they will only pay 40% higher rate tax on the top £7,000 of their income. When you factor in their personal allowance and the tax they pay at basic rate, the effective rate of tax on all their income is 18.4% – less than half the 40% headline rate.

By the same token, basic rate taxpayers won’t pay 20% tax on their retirement income. And with growth in the personal allowance outstripping inflation, effective rates have been coming down year on year, as this chart shows. In 2016/17 the effective rate is around 9% and, of course, that ignores that 25% of pension fund can be taken tax free.

 

Effective tax rates are much lower than the marginal headlines rates. The table below shows the effective tax rates on a range of net incomes and the amount of pension withdrawal required to provide it.

Income needed (after tax) Gross
withdrawal
Tax rate
(no TFC)
£12,000 £12,250 2.1%
£24,000 £27,250 12.0%
£36,000 £42,250 14.8%
£48,000 £62,000 22.6%
£60,000 £82,000 26.9%

Using more realistic effective rates on the income in retirement paints an altogether different picture.

Savings vehicle Tax relief / Saver’s bonus  Tax rate paid on income Pay  Pot Get back Gain
Pension 67%
(40% relief)
20% £100 £167 £141* 41%
Pension 25%
(20% relief)
10% £100 £125 £115* 15%
LISA 25% 0% £100 £125 £125 25%

* Assumes 25% tax free cash taken.

Employer pension contributions – the other half of the story

But choosing LISA over pension could see employees missing out on valuable employer contributions to their pension. Even the minimum contributions under auto-enrolment make a huge difference in what savers will get back.

Savings vehicle Member pays (4%) Taxman pays (1%) Employer pays (3%)  Pot Get back Gain
QWPS £100 £25 £75 £200 £170* 70%
QWPS £100 £25 £75 £200 £185** 85%
LISA £100 £25 £0 £125 £125 25%

* Including 25% tax free cash and assuming 20% tax on income.
** Including 25% tax free cash and assuming 10% tax on income.

Salary sacrifice – the final encore

Many employers operate salary sacrifice for their workplace pension. For a basic rate taxpayer, this would see a 12% employee NI saving which is added to the fund. Add to this the fact the many employers also pass on some or all of the employer NI savings too and this makes pensions impossible to beat.

LISA’s place

This doesn’t mean that LISA isn’t valuable savings option – far from it. LISA is a great addition to pension saving – giving higher rate taxpayers under 40 up to £45,000 in tax relievable retirement savings from next year.

Anyone eligible who has already maximised their pension funding options will be able to save an additional £5,000 towards their retirement. And they could also pay towards a spouses LISA even if their spouse has no earnings, giving non-working individuals the ability to get tax relief on combined savings (pension and LISA) of up to £8,600 a year.

The ability to access funds to help to secure the average first time buyer deposit of just under £33,000 to get a foothold on the property ladder will prove popular with younger savers. But this is only open to first time buyers, so existing homeowners will have to wait until 60 for penalty free access.

Any other access before age 60 would incur a loss of the bonus and a 5% tax charge.

Savings options from 2017
Pension
Lifetime ISA
ISA
Savings limits and incentives
Max annual saving (including incentives/tax relief) £40,000 £5,000 £20,000
Government incentive 25% of net contribution,
plus tax relief at higher rates if applicable
Up to £1,000 None
Earnings required? Yes No No
Employer contributions allowed? Yes No No
Saving via salary sacrifice? Yes No No
Investment growth Tax free Tax free Tax free
Impact on other saving Additional to ISA subscription Part of ISA subscription Reduced by LISA saving
Important ages
Minimum age to open account 0 18 18*
Maximum age to open account 75 40 None
Govt. incentive/tax relief received until age 75 50 N/A
Age of access with no penalty 55 60 – or on purchase of 1st home Any time
Cost of exits
Tax on ‘allowed’ withdrawals 25% tax free, balance at member’s rate of income tax Tax free Tax free
Penalty on early withdrawal Unauthorised payment charge (unless on grounds of ill health) Loss of Government incentive and any growth on it, plus 5% charge on amount withdrawn (unless towards purchase of 1st home) None
On death before 75 Can be inherited tax free by anyone Can be inherited tax free by spouse/civil partner, otherwise potential for IHT at 40% Can be inherited tax free by spouse/civil partner, otherwise potential for IHT at 40%
On death after 75 Can be inherited by anyone, but taxed at beneficiary’s rate of income tax Can be inherited tax free by spouse/civil partner, otherwise potential for IHT at 40% Can be inherited tax free by spouse/civil partner, otherwise potential for IHT at 40%

* Junior ISA available from birth, but can only be opened by child themselves from age 16.

 

 

Source: Standard Life