The tax treatment of pensions makes it more likely that people will utilise them as an inheritance vehicle rather than a source of retirement income, according to the Institute for Fiscal Studies (IFS).
IFS has released a report titled: ‘Death and taxes and pensions’ which proposes the end of generous tax treatment for pensions. It shows that between 2010 and 2012, defined contribution pension pots accounted for 15 per cent of the wealth of people between the ages of 45 and 59 whose total net worth surpassed £500,000. This percentage had significantly risen to 24 per cent by 2018–20. This is due to a decline in the average level of non-pension wealth within this group rather than a rise in the average size of pension pots among them.
IFS advises levying basic rate income tax on any money still in a pension at the time of death. Currently, the fund is exempt from income tax if the person passes away before the age of 75. It also suggests that pensions be taken into account when determining an estate’s value for inheritance tax purposes.
Hargreaves Lansdown senior pensions and retirement analyst Helen Morrissey says: “The tax treatment of pensions on death is extremely generous – pensions escape inheritance tax while other types of assets do not – and where death occurs before the age of 75 there is no income tax to pay.
“The IFS is right to point out such treatment may lead to behaviour where some people stockpile money in pensions and leave them untouched while drawing down on other assets. The report gives an example of a couple being able to pass on an estate of well over £3m inheritance tax free through the current system – it’s an extreme example but shows there are gaps in the system that could be exploited.
“Applying basic rate income tax to all funds remaining in a pension on death, regardless of age, would apply across the board with even non-taxpayers, such as children, becoming liable – it’s certainly a better option than the 55 per cent charge that used to apply where a pension had been accessed or death occurred post age 75.
“The main benefit of reviewing and potentially reforming how pensions are treated on death is that it could incentivise people to use their pension to provide a secure lifetime income. It could also remove one reason for retaining the lifetime allowance.
“We also need to consider whether these proposed changes become a hindrance to people trying to provide for their family. For instance, someone dying pre-age 75 could still have a young family to support and their pension could be viewed as life insurance rather than as an inheritance tax vehicle.
“The report highlights the hugely complex world of pension tax and the importance of a wholesale look at how it is approached. For years we have seen a series of iterative changes – tweaks to lifetime and annual allowances for instance and these have caused problems and we need an overarching view to reduce the risk of unintended consequences. It is time for the issue of pension taxation to be reviewed wholesale rather than piece by piece.”
Quilter head of retirement policy Jon Greer says: “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. In the grand scheme of things, the lost revenue to the exchequer from this policy may not be significant compared to other areas of government spending, but may have a very positive effect for a material number of families which are not high earners or fit into some of the extreme examples highlighted.
“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 £1 billion 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.”