Which is more advantageous: Lifetime ISA or SIPP?

Question

I should preface that I am a self employed sole trader in my early twenties, and a basic rate taxpayer averaging somewhere between £28-32,000 per annum. The variation not only arises due to the nature of my consultancy work, but also because I actually serve as an independent contractor for a US company, so am paid in a dollar wage converted.

I am trying to evaluate which is more advantageous given my situation for saving into a pension - a Lifetime ISA, or a SIPP? I already have a Help To Buy ISA too, so I believe I would have to potentially transfer this and make use of the transfer window this tax year.

I read the following link: MSE - Lifetime ISAs when I noticed the following line:

WARNING! Unless you're a self-employed basic-rate taxpayer, using a pension to save for retirement is likely to be far better than a LISA

I am self-employed, and I am basic-rate... although these circumstances may change and (hopefully) I would see an income raise that may put me in a higher tax bracket. My father (employed, higher earnings) recommended a HL Vantage SIPP saying that the returns in later years skyrocket as interest compounds, even though it may seem insignificant currently.

That said, I feel this may not be making best use of my funds right now, especially given that I will probably still end up wanting to purchase a house at some point (another potential advantage of LISA) and also any other general attractions that I may wish to experience while being young enough to do so.

So - should I go for a LISA, or a SIPP - or even a stocks and shares ISA (I understand there's risk to capital involved)? Potentially a combination of the aforementioned?

Answer 1

Whilst you're a basic rate taxpayer, and you have LISA allowance left, a LISA is the best bet.

With a pension, you get to save tax as you put into the pension, and your money grows tax-free. But when you take it out, most of the money is subject to income tax like any other income, though you can take 25% tax-free.

In contrast, the LISA comes from after-tax income, gets a government bonus of 25%, and then grows tax-free and you can take the money out tax-free.

So if you have £100 of gross income now, the two scenarios work out as:

• Pension: Get £80 of take-home pay, put it in your pension where it gets "grossed up" againt to the original £100. It grows, say by 100% to keep the maths simple, and you end up with £200 in your pension fund.
  • If you are below the personal allowance when you take it out, you can take it all out tax-free and you have £200.
  • If you are a basic rate taxpayer, you can take out £50 tax-free, pay 20% tax on the rest, and you have £170.
• LISA: Get £80 of take-home pay, put it in your LISA where it becomes £100 with the government bonus. It grows, again by 100%, and you end up with £200 in your LISA which you can always take out tax-free.

A LISA also gives you more options: with a pension you'll be able to take out your money probably at age 57 and possibly a bit later if they increase the age again, with a LISA you'll either be able to take it out at age 60, or to buy your first home.

Once you have filled up the LISA allowance - which is £4k/year - the decision is a bit harder. You can either use a normal ISA, which doesn't have the government bonus, or a pension. Given the 25% tax-free part, a pension is usually better. For example in the above scenario, with a normal ISA, you end up with £160.

Note that the choice of tax-exempt wrapper is mostly independent of what you invest in - e.g. stocks and shares, or whatever. You'll need to choose a provider that offers the investments you want, and look carefully at their charges. Either way the growth while inside the wrapper is tax-free.

Once you become a higher-rate taxpayer, the balance above changes, and the pension probably wins just in terms of money available at retirement. But the LISA contributions you made while a basic-rate taxpayer were still worthwhile. Also you might choose to keep focusing on the LISA even as a higher-rate taxpayer, if you're more interested in using the money as a deposit on a first home than on saving for retirement.