The Motley Fool

Forget a cash ISA! A Lifetime ISA could be the choice to boost your State Pension

The prospects for the State Pension appear to be relatively downbeat. The age at which it’s being paid is expected to increase to 68 over the next two decades. Further rises during this time cannot be ruled out, since an ageing population which is living longer means that its cost may become increasingly difficult to meet.

In addition, the ‘triple lock’ which states that the State Pension will rise by the higher end of average wage growth, inflation or 2.5%, may come under threat. The political and economic outlook for the UK remains uncertain, and this could influence decisions regarding the State Pension in future.

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As such, having a supplementary income may become increasingly important over the long run. While many individuals have cash ISAs, the reality is that a Lifetime ISA may be a better way of obtaining the financial freedom that everyone seeks in retirement.

Cash ISA

While a cash ISA was popular among savers when all interest income received was subject to tax, changes to legislation mean that it’s lost a significant part of its appeal. Today, the first £1,000 of interest income received by an individual within savings accounts is not subject to tax. And since 1.5% is likely to be the highest rate of interest available on cash savings, this means that an individual would need to have over £66,000 in cash in order to benefit from a cash ISA’s tax status.

Furthermore, a return of 1.5% on cash savings is below inflation, which currently stands at 2.3%. In the short run, a 1.5% return is unlikely to provide a sufficient income in retirement. In the long run, it’s set to lose value when inflation is factored in, which may mean that using a cash ISA leads to disappointment in older age, leading to a relatively small nest egg.

Lifetime ISA

In contrast, a Lifetime ISA offers a government bonus of 25% on amounts invested up to a maximum of £4,000 per year. Although there are penalties on withdrawals under the age of 60, unless it’s for a first-time home purchase, in the long run a lifetime ISA offers tax advantages. Capital gains tax does not apply to lifetime ISAs, while dividends received don’t count towards an individual’s £2,000 annual limit – above which a tax rate of 7.5% is normally applied.

Alongside its tax advantages, a Lifetime ISA provides the opportunity to invest in a variety of stocks. It’s possible to obtain dividend yields well above the FTSE 100’s yield of 4.5%, with a number of mid- and large-cap shares offering high single-digit income returns. They could boost what’s a relatively meagre State Pension of £164 per week, as well as provide the opportunity to generate capital growth in the long run. As a result, a Lifetime ISA seems to have far more appeal than a cash ISA.

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