This is a short piece to help everyone understand what the main differences are between an ISA, a LISA (Lifetime ISA) and a Pension and what you might want to think about before choosing where to invest your tomorrow money, today.
So what’s Similar
In the first instance all 3 products are well known to provide tax benefits and so the appeal is there to use them as investment vehicles. Once your money is invested into any fund within one of these ISA or pension products, it enjoys a tax shelter which effectively wraps your money up so it can grow free of any tax.
It is no major secret that all 3 investments have great tax benefits to the saver. What is different about the 3 options relates largely to the tax on what you invest/withdraw, and the accessibility of your funds.
- Access your Pension at age 55
- Access your LISA at age 60 (unless you are using the funds to buy your first property, or you are prepared to repay the bonus you received, which will be 25% of what you withdraw)
- Access your ISA at any time
There’s a handy mnemonic to help understand the difference between ISA and Pension:
ISA: TITFO (Taxed In - Tax Free Out)
Pension: TFITO (Tax Free In – Taxed Out)
This is to say that if you earn £1000 and are a basic rate taxpayer, you’ll receive £800 after tax (Ignoring N.I.). You could invest that £800 in an ISA but the full £1000 could be invested in a pension – tax free in! With an ISA you pay no tax on withdrawals – Tax free out!
Conversely, with a pension you may be taxed on the withdrawals. However, we shouldn’t be too quick to forget that, with a pension we got to invest the £200 difference. This can make quite an impact over time, which is highlighted in our article on the magic of compound interest. Also, with a pension you get 25% tax free when you choose to take funds and you can use your normal income tax allowances.
I am frequently asked whether a “pension is better than an ISA” or vice versa. Choosing the right investment for you really does depend on what you are trying to achieve, when you need access and your overall circumstances.
It can of course make sense to utilise both vehicles. As we go through life our circumstances change. Knowing the basics will help you to determine what your next steps are with your money.
So what about the LISA??
The Lifetime ISA was born in April 2017 and provided an investment for people under 40 (and over 18) to invest up to £4,000 per tax year. At the end of each tax year, the Government provides a 25% bonus to your investment or £1 for every £4 invested.
You are not committed to how much you must save into the Lifetime ISA, however if you did save the maximum from age 18 to age 50 (if you have a LISA at 40, you can keep contributing and receiving bonuses until age 50), you'll receive a whopping £32,000 in bonuses.
What is often overlooked is that you get the same tax benefit as a basic rate taxpayer paying into a pension, up to the £4,000 maximum LISA investment per annum. Taking numbers from our example above:
£800 paid in + 25% LISA bonus = £1,000.
So this means for a basic rate taxpayer the mnemonic is effectively TFI-TFO – (Tax free in - Tax Free Out). The LISA, however, does not offer any further uplift for a higher rate taxpayer in the way that a pension does.
If you want to access your money, you can take it all without any penalty if it is for your first home (only your first home purchase, and up to £450,000), you are age 60 or over, or you are terminally ill. Be aware, though, if you need it for any reason not in the above list, you'll have to pay back 25% of what you withdraw.
All of these factors require us to take time to understand how we make sure our tomorrow money is cooking in the right pot!.
Author: S Champaneria
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