The Institute for Fiscal Studies (IFS) has published a controversial report suggesting that pensions should be liable for both income and inheritance tax (IHT) when the scheme member dies.
The rationale behind these proposals is that they would make the tax treatment of pensions more “coherent”, “fairer and economically efficient”, according to the IFS.
The reforms would mainly apply to defined contribution (DC) pensions and would consist of six main points:
- Removing the use of pension as a vehicle for tax-incentivised bequests;
- Applying basic rate income tax on the funds that remain into a pension at death or extending income tax rules to those who inherit a pot from someone who dies before the age of 75;
- Including pension pots in the value of estates at death for inheritance tax purposes;
- Raise revenue by applying IHT on pensions and force people to use their pot to fund retirement rather than leaving it alone for as long as possible – the IFS estimates this could raise around £1.9bn ($2.3bn, €2.2bn) a year;
- If the government does not want to increase the “overall yield” of IHT, it could use the revenue to cut the IHT rate and/or increase the threshold – for instance, reduce the rate from 40% to 30%; and
- Introducing reforms “swiftly” and apply them gradually by “date of death” to avoid incorrect expectations on the ability to pass down tax-free wealth.
Frustration
It comes as no surprise that the IFS’ proposals did not receive a warm welcome from industry commentators.
Alice Guy, personal finance editor at Interactive Investor, is worried that these changes will impact trust and confidence on the pension system; while John Greer, head of retirement policy at Quilter, believes these reforms would only be for the benefit of the Treasury.
Guy said: “Today’s report is strong stuff and the content will be up for debate, to say the least. As part of this conversation, it’s crucial that trust in pensions is preserved and that investors continue to see pension saving as a tax-efficient and attractive in the long-term.
“Inheritance tax and pensions are highly emotive and any changes could have a significant impact on trust and confidence in the pensions system.
“Changing the rules around inheritance tax and pensions could significantly impact on the attractiveness of pension saving and income drawdown, whereas defined benefit pensions with survivor benefits would not be impacted by a rule change.
“Pensioners with a defined contribution pension need to keep their pension pot invested, to enable them to draw an income right through retirement. Those who have investments left when they die are not necessarily wealthy but are simply keeping investments to enable them to draw an income for as long as they live.
“Any changes would disproportionately impact on unmarried couples, who are not entitled to spousal IHT exemptions and may have significant tax to pay on an inherited pension.
“More than anything, retirement outcomes are currently being compromised by a lack of understanding about pensions. It’s important that we focus on making sure the next generation are retirement-ready.
“Financial education plays a crucial role and Interactive Investor remains frustrated by the clear lack of joined up, properly resourced financial education in the UK.”
Unintended consequences
Quilter’s Greer added: “Ending the tax treatment of pension pots on death on grounds of ‘fairness’ only makes the situation ‘fairer’ for the Exchequer, not necessarily families especially those who may lose a loved one at a relatively early age where the financial impact can be significant.
“Changing the rules may have some unintended consequences too, such as pushing people to take their tax-free cash lump sum earlier than perhaps they would ordinarily do, so potentially reducing the overall amount they have available for retirement.
“The financial impact it might bring to some families of people who die early should not be discounted. I know that losing a loved one is already a difficult and emotional time and having to worry about the financial impact of that loss can add even more stress. The tax-free nature of a pension pot on death at earlier ages can provide some much-needed financial support for those families.
“Given that IHT thresholds were recently frozen for a further two years at the Autumn statement netting the government a further £1bn in the main due to property wealth, more and more people will be paying inheritance tax anyway. These additional changes to pensions would drag even more people into paying what is often touted as one of the nations most hated taxes.
“Ensuring that everyone has the ability to save for their retirement and have some financial security in their later years is important for both individual well-being and the overall health of the economy.”
