Growing a Lifetime ISA for retirement

One of the now-discarded policies from the not-so-mini budget recently was to reduce basic rate Income Tax from 20% to 19%; this would have reduced Income Tax paid but also the basic rate tax relief claimed on pension contributions. Had it been implemented some may have looked at the Lifetime ISA, with its 25% government bonus, more favourably than a pension. Even with the U-turn on the basic rate cut, meaning pension tax relief is still the equivalent of the 25% Lifetime ISA bonus, LISAs may still be seen as useful for retirement savings.

LISAs have had a slow start since their introduction in 2017, but the number of accounts subscribed to per year has gradually grown since then with over 500,000 LISAs subscribed to in the 2021/2022 tax year.

LISA funds can only be withdrawn for two purposes without incurring a penalty: a property purchase for a first-time buyer or once the investor has reached age 60. Over 50,000 people used a LISA to buy their first house in the year to 5 April 2022, which brings the total number of individuals who have used this scheme to purchase a property to 118,100.

As a LISA can only be opened before age 40, we will have to wait a number of years before the first LISA holders reach age 60 so it remains to be seen whether it will become a source of retirement income for many. However, one advantage of using the LISA this way is that entire fund would be available tax-free from age 60 onwards, compared to pension income with only 25% tax-free and the rest taxed as income.

There are downsides to the LISA: the annual subscription limit is only £4,000 so a maximum total of £5,000 with the government bonus included. The current pension contribution annual allowance is £40,000 and if you factor in the ability to carry forward unused allowance those with the earnings to support it can make substantially higher contributions than to any of the ISA products available.

And while the 25% LISA government bonus replicates the basic rate tax relief, crucially, higher and additional-rate taxpayers saving in a pension can claim an extra 20% or 25% tax relief from HMRC. A higher rate taxpayer can make a gross pension contribution of £5,000 for a net cost of £3,000 once tax relief is accounted for, if in retirement they withdraw this amount as a basic rate taxpayer they would receive £4,250 (tax free lump sum of £1,250 and £3,000 net income after tax), which is a 41.67% uplift on their initial net cost compared to just the 25% in a LISA.

When the LISA was first announced there were fears that they would complicate investing for retirement and even see some savers opt out of their workplace pensions and miss out on employer contributions, but so far the statistics don’t show that LISAs are being viewed as a pension replacement. However, for some clients there are compelling reasons why the LISA can be used as a complement to the tax benefits offer by pensions.

ISA stats from GOV.UK