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SIPP vs. Lifetime ISA – which is the better for pension investment?

written by Bella Palmer

We are all aware, or really should be, that with one of the poorest state pension provisions in the developed world, it’s not a good idea to be fully reliant on it when we reach retirement age. Which is why almost all of us save into some kind of private pension provision in the form of a workplace, private or DIY pension. For those under 40, the Lifetime ISA has also become an alternative.

But do any of the options available offer advantages over the others? Is there a better long-term choice when it comes to pension savings and investments? Or does it boil down to personal circumstances?

Here we’ll look at important differences between the main options when it comes to long term investments with a view to retirement.

Lifetime ISA bonus or pension wrapper tax relief – which is worth more?

The Lifetime ISA, launched in 2017, was designed to help younger savers invest for retirement or buy a first home. Potentially both. The Lifetime ISA, which a maximum of £4000 a year can be saved into (and counts towards your overall annual ISA allowance of £20,000), comes with a 25% government bonus. So, £4000 is topped-up to £5000 with the government’s contribution.

Pension wrappers on the other hand come with 20% basic tax relief. At first glance a 25% top-up sounds better than 20% tax relief. But it actually amounts to exactly the same thing. For every £1 paid into a pension product, a basic tax rate payer effectively contributes 80p, with the other 20p coming in the form of tax relief.

And if you pay 80p into a Lifetime ISA, a 25% bonus on that also equals 20p to bring the total up to £1 - exactly the same.

For higher-rate tax payers the comparison has a different result and a pension wrapper becomes the more attractive of the two options. If you pay 40% or 45% tax, you’ll still get a maximum 25% top-up on Lifetime ISA contributions. But if you pay into a pension, you’ll receive tax relief based on your rate, regardless of if it’s 20%, 40% or 45%.

That means a higher-rate tax payer only pays 60p towards each £1 in their pension and a top-rate saver even less at 55p.

Another advantage to paying into a pension is that tax relief is available on up to £40,000. The 25% top-up on Lifetime ISA contributions is only paid on up to £4000 a year.

Employers also contribute to pension savings

A further strength of pension savings is that your employer is also obliged to contribute to all payments you make. Unless you’ve opted out of a workplace pension, your employer has to make a minimum contribution of 3% of your salary every year. Your employer has no obligations in connection to any Lifetime ISA payments you may make.

If you do have a workplace pension, it is unlikely that it makes sense to opt out and favour payments into a Lifetime ISA instead as this means giving up employer contributions. Or at least, not before the point you’ve maxed out the contributions your employer is obliged to make respective to your own.

Tax on Lifetime ISA and pension funds

Another factor to consider is when you are able to access funds held in a pension wrapper compared to Lifetime ISA. State pension can be claimed from the age of 66, though it can be deferred. Most workplace and other pensions can be accessed from the age of 55, though that increases to 57 from 2028.

Money paid into a Lifetime ISA, however, is locked up until you turn 60 - if you haven’t used it for the deposit on a first home. In favour of Lifetime ISA fuds is that they are tax-free for life. By contrast, only the first 25% of income drawn down from a pension is tax-free. That applies to all defined contribution pension products, from workplace pensions to SIPPs and stakeholder pensions.

A Lifetime ISA offers a match to basic-rate tax relief upfront and there is also no tax to pay down the line. Pension contributions come with upfront tax relief but 75% is then still taxed as income when withdrawn.

That means if you are a basic-rate taxpayer and you employer is not contributing to your pension, a Lifetime ISA is the more attractive option. It can also be a good alternative for the lucky few who have used up the entire £1.07 million lifetime allowance for pension tax relief. A Lifetime ISA could then be a good home for any additional extra savings.

A final consideration is that pensions can be passed on to loved ones tax-free if you die. Funds held in a Lifetime ISA, on the other hand, will be counted as part of an estate and may be subject to inheritance tax.

Withdrawals – do Lifetime ISAs or pensions have hidden costs and restrictions to be aware of?

A further consideration to keep in mind when deciding to pay into a Lifetime ISA or SIPP is that the former comes with a number of restrictions that do not apply to pensions. It’s a less flexible product. Firstly, you can only open a Lifetime ISA up to the age of 40 and pay into until 50, though some experts are confident the government will extend those cut-off ages over time.

Payments into a pension, on the other hand, have no limitations on when you can start or finish. You can even keep paying into a pension after retirement, though after you start drawing down an income there is ceiling of £4000 a year for additional tax-free contributions.

If you wish to take money out of a Lifetime ISA at any point before the age of 60, other than as a down payment on a first home or in the unfortunate circumstances of terminal illness, early withdrawal fees apply. Early withdrawal charges rise from 20% now to 25% as of April 2021. That means if you access pension savings in a Lifetime ISA before the age of 60, you essentially forfeit the government top-up.

Lifetime ISA vs. pension products – a cost comparison

There are two kinds of Lifetime ISA – cash and investment. If you are saving into a Lifetime ISA long term as a retirement fund, rather than for a first home deposit which usually means a timeframe of between 2 and 5 years, it is probably better to pay into a stocks and shares format.

Cash Lifetimes ISAs usually avoid management fees but over a longer-term period will offer poor returns. Cash Lifetime ISA interest rates don’t get much better than 0.8% p.a. and inflation is currently running at around 2%. Which means the purchasing power of cash held in a Lifetime ISA is likely to be eroded over time. Potentially significantly.

Historically, over longer periods like 20 years, compounded returns from typical stock market investments work out at an average of 6%-8% p.a. So if you are contributing to a Lifetime ISA with retirement in mind, it is probably wise to do so only through an investment Lifetime ISA.

Moneybox, a popular provider of Investment Lifetime ISAs, charges £1 a month as well as a platform fee of 0.45% before fund management fees. AJ Bell charges 0.25%-a-year, capped at £3.50 a month. A SIPP held with AJ Bell comes with the same 0.25% custody charge, but maximum charges are capped at a higher £10 a month. That’s because it’s possible to save over 10 times more into a SIPP, compared to a Lifetime ISA.

Because SIPP fees are capped or reduced once your pot is worth over a certain value, fee savings compared to setting up an Investment Lifetime ISA separately for extra saving might mean it’s better to stick to just the pension product.

Ultimately, it comes down to personal circumstances. Because Lifetime ISAs and different pension products all have slightly different restrictions, strengths and weaknesses, a combination, and one that also includes a standard ISA, may be the best option. If unsure whether Lifetime ISA or pension contributions would make most financial sense for you personally, it might be beneficial to talk to a qualified financial advisor. 


This article is for information purposes only.

Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.

There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

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