What is the Lifetime ISA? How the retirement income option could help you

lifetime ISA Portrait of florist in apron working at her own flower shop, using laptop and calling on the smart phone. She is leaning on wooden counter. She is arranging logistics, and delivery, taking orders
The lifetime ISA has real benefits for groups such as the self-employed. (satamedia via Getty Images)

Although pensions are a great way to save for retirement, but they are by no means the only way. Another lesser-known option is the Lifetime ISA.

The Lifetime ISA — otherwise known as LISA — was introduced with the aim of helping people to either save for their first home or for retirement. You can save up to £4,000 per year into your LISA and in return you get a government top up of 25%.

It’s a great way of getting your house deposit off to a good start and for those saving for retirement the bonus acts in a very similar way to basic rate tax relief on a pension. Any income taken from a LISA is also tax free. In addition, you can access the money in a LISA early if needed though it would be subject to a penalty charge.

For people receiving an employer contribution to their workplace pension or for those benefiting from higher rate tax relief on their contributions then the pension is still a clear winner. However, the LISA has real benefits for groups such as the self-employed who may be hesitant to tie up money into a pension until the age of 55. Self-employed earnings may be variable and so the ability to access the money in a LISA early should times get tough is important.

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Even if you aren’t self-employed the LISA has real benefits. In addition to being a valuable retirement income vehicle, you could use the savings in a LISA to pay off your mortgage before you hit retirement. You could also use it as a bridging income from the age of 60 if you retire before state pension age.

For starters, LISAs can only currently be opened by people between the age of 18-39. Given that many people become self-employed later in life, we risk thousands of people missing out on making use of this product. In addition, the 25% penalty on early withdrawals not only removes the effect of your government bonus, but also a chunk of your hard-earned savings as well.

As an example, if you save the full £4,000 into your LISA then you will receive a 25% bonus of £1,000 which will top you up to £5,000. However, if you then need to access that money before the age of 60 (for any reason other than to buy a first home) you will pay a 25% penalty on the full £5,000 which means you lose £1,250.

Read more: What is the true cost of the UK state pension?

The Hargreaves Lansdown Savings and Resilience Barometer estimates that changing the rules to allow people to open a LISA and contribute to it until the age of 55 could help around 680,000 households with a self-employed person who pays basic rate tax.

In addition, if the government reduced the penalty to 20% for self-employed people who need to access the money in their LISA early, this could help the LISA to boost the retirement prospects of the self-employed, according to Hargreaves Lansdown.

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