IFS - Overly generous tax treatment of pension pots at death needs to be swiftly ended
Pensions are treated more generously by the tax system as a vehicle for bequests than they are as a retirement income vehicle.
Keeping savings in a pension can be a highly effective way of avoiding inheritance tax. The sooner this anomaly is addressed the better.
In a new report, Death and Taxes and Pensions, published today and funded by the abrdn Financial Fairness Trust, IFS researchers set out proposals that would make the tax treatment of pensions at death fairer and more economically efficient. The revenue raised by moving to a more sensible system, even if relatively modest in the near term, could be substantial in the longer term. If government didn’t want to raise the overall level of inheritance tax, then the revenue raised could be used to cut inheritance tax in ways that made the overall system both fairer and more efficient.
The report identifies the following problems:
- Inheritance tax. Any funds that remain in a pension at death (at any age) are not subject to inheritance tax. As such, there is a substantial incentive, for those who can, to use non-pension assets to fund their retirement while preserving their pensions for bequests. To give the most extreme example: a married couple could each leave £1,073,100 in their pensions free of inheritance tax (i.e. £2,146,200 in total), whereas if they both bequeathed the same amount in other financial assets instead there could be a total inheritance tax bill approaching £600,000 (or more).
- Income tax. Pension contributions are already free from income tax, but usually money received from a pension is taxed instead. Income tax is payable on money received from a pension pot inherited from someone who died at or after age 75. But when someone dies before age 75, funds remaining in their pension escape income tax entirely. For a basic-rate taxpayer, the difference in income tax between inheriting a £100,000 pension pot from someone who died the day before they turned 75 and someone who died the day after turning age 75 would be £20,000. For a higher-rate taxpayer receiving a £1,000,000 pension pot, this difference in income tax would rise to £400,000.
Growth in defined contribution pensions, the introduction of ‘pension freedoms’ and the strong tax incentives described above all mean that more pension wealth is starting to be bequeathed. There is now a premium on announcing any reform quickly. The more we delay, the worse the problem gets. Swift action would mean people no longer making financial decisions under what should be false expectations of future tax breaks.
Fortunately, the solutions are simple:
- Inheritance tax. Pension pots should be included in the value of estates at death for the purposes of inheritance tax. If we are to have an inheritance tax, it should apply evenly across all forms of wealth.
- Income tax. Basic-rate income tax could simply be levied on all funds that remain in pensions at death. Alternatively, current income tax rules could extend to those inheriting pension pots from someone who dies before age 75. This would mean levying income tax when the person inheriting the pension pot withdraws the funds from it regardless of the age of death of the deceased.
Together these reforms would raise revenue, make the system fairer and remove the perverse incentive to avoid using a pension to fund retirement. In the longer term, if those benefiting from pensions freedoms were to leave half their pension pots intact at death, these changes could raise the equivalent of around £1 billion a year in extra inheritance tax revenue. That would be enough to reduce the rate of inheritance tax from 40% to 35%. Or the funds raised could be used to help meet growing pressures on public services such as the NHS and adult social care.
As with any increase in wealth taxes, some degree of retrospective taxation would be inevitable – which is precisely why change needs to be announced and implemented as soon as possible. The transition could be eased for both the income tax and inheritance tax by gradually phasing in reforms.
Isaac Delestre, a Research Economist at IFS and an author of the report, said:
‘Whether by accident, design or inertia, the tax treatment of pension pots at death has become increasingly eccentric. The situation where the tax system treats pensions more generously as a vehicle for bequests than it does as a retirement income vehicle needs to be swiftly ended. With the amount of wealth held in defined contribution pensions increasing year-on-year the unfairness and inefficiency this bizarre tax treatment creates will only get worse.
‘Pension pots should be included in the value of estates for the purposes of inheritance tax and income tax should be charged on inherited pensions, regardless of how old a person is when they die. The coalition government missed the opportunity to fix the tax treatment of pensions at death when pension freedoms were introduced. It is not yet too late to act, but the longer the government delays, the more painful such reforms will become. Failure to embrace relatively small reforms now will leave a legacy for which the Chancellor’s successors will not thank him.’
Mubin Haq, Chief Executive of abrdn Financial Fairness Trust, said:
‘Those with wealth are increasingly being urged to use their pension pots as a way to pass on inheritance. This legal route bypasses inheritance tax and in some cases income tax. Whilst this avoidance measure is open to all, it is the wealthiest in society who are set to benefit the most, escaping tax bills which for a couple could otherwise be around £600,000 or higher. Pension pots are there to fund retirement, and government must act to close this loophole.’
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