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The government, as of 6th April, has thrown a new ‘saving for retirement’ option into the mix. Not sure if you should open a Lifetime ISA, contribute to your pension, or do a bit of both? We’ve put them head-to-head to help you work it out.

If you’re over 18 and under 40, you now have another potential savings option into the mix: the Lifetime ISA. Designed to help you save money for two big milestones – buying your first home and retiring – it comes with a whopping 25% government bonus. So how does it stack up as an alternative to your pension?

The Lifetime ISA: how it works

The Lifetime ISA is a new government initiative to encourage young people (aged 18-39) to save money for their first home or retirement.

You can save up to £4,000 each tax year, starting 6 April 2017, until you’re 50. And you’ll get a 25% government bonus on everything you contribute. That’s a potential £1,000 extra per year.

Your original savings and the bonus both earn tax-free interest. For the 2017/18 tax year, the government bonus will be paid as a lump sum after the end of the year. From April 2018, it will be paid monthly, giving the free money even more chance to accrue interest.

You can access the money in your Lifetime ISA to buy your first home worth less than £450,000, once you’re 60, or if you’re terminally ill. If you need to use it for something else, you’ll have to pay a 25% government withdrawal charge (the withdrawal penalty will be temporarily reduced from 25% to 20% from 6 March 2020 till 5 April 2021 due to coronavirus) meaning you’ll get back less than you’ve put in.

Head-to-head: the Lifetime ISA versus the pension

So, given that it has been designed to help people save for retirement, should the Lifetime ISA be used as an alternative or complementary measure to a traditional pension? Whether the Lifetime ISA works for you as a pension is complicated, and depends on several factors.

Importantly, Lifetime ISAs and pensions are taxed differently. A pension is tax-free when you pay into it, thanks to tax relief on the whole contribution, but you’re taxed on the money you withdraw from it. A Lifetime ISA is the other way around: you contribute money you’ve already paid tax on, but eligible withdrawals are tax-free.

Plusses for a pension

If you’re employed, you may receive employer-matched contributions towards your workplace pension. Your employer has no obligation to match contributions to your Lifetime ISA.

If you’re a higher rate taxpayer, you get 40% tax relief in your pension. Additional rate taxpayers get 45%. This saving easily beats the government’s 25% top-up on Lifetime ISA contributions.

If you need to access your money before you’re 60, you may be better off with a pension because you can access your money once you’re 55. With a Lifetime ISA, you have to wait until you’re 60, unless you’re buying your first home or terminally ill, to withdraw your money without paying a penalty.

Plusses for a Lifetime ISA

If you’re unsure of what you’re saving for, the Lifetime ISA offers more flexibility than a pension: you can use it to save towards buying your first home, retirement, or both. A pension is only for retirement.

If you need to access your money ‘early’ (and not because of a critical illness or death), and you’re willing to pay a penalty, the Lifetime ISA wins. Aside from special circumstances, pensions don’t allow early withdrawals. However, if you already think there is a good chance you’ll need to access the money, you may be better off with a normal ISA as you will have to return the government bonus and pay a penalty.

If you’re self-employed, you won’t benefit from employer-matched contributions, so a Lifetime ISA – and the 25% government bonus – may win over a stakeholder pension or SIPP.

And the winner is…

As a rule of thumb, if you’re employed, continue to pay into your workplace pension and reap the benefits of any employer-matched contributions. These contributions plus the tax relief are likely to outweigh the Lifetime ISA 25% government bonus.

If you’ve maxed out contributions on your workplace pension and you want to save more, the Lifetime ISA could be a good option. You have to pay tax if the savings in your pension pots exceed £40,000 in a year, or £1 million in total.

If you’re self-employed, your tax status and personal situation will come into play to work out which is a better option for you. Self-employed higher rate taxpayers will benefit more from paying into a pension (the tax relief wins over the Lifetime ISA bonus). It’s not as clear cut for self-employed basic rate tax payers though, and it’ll be about working out which scheme works for you.

See what you could save

If you think a stocks and shares Lifetime ISA may be right for you, you can use the Nutmeg Lifetime ISA calculator to see how much you could save.

If you’re still not sure whether the Lifetime ISA is right for you, you may want to download our PDF guide.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest.

A stocks and shares Lifetime ISA may not be right for everyone. You must be 18–39 years old to open one. If you need to withdraw the money before you’re 60, and it’s not for the purchase of a first home up to £450,000, or a terminal illness, you’ll pay a 25% government penalty. So you may get back less than you put in.

Compared to a pension, the Lifetime ISA is treated differently for tax purposes. You may be better off contributing to a pension.

If you choose to opt out of your workplace pension to pay into a Lifetime ISA, you may lose the benefits of the employer-matched contributions.

If you are unsure if a Lifetime ISA is the right choice for you, please seek financial advice.