Death and taxes are famously two of life’s certainties. Yet the combination of the two is uncertain and subject to change.
The recent proposals from the Institute for Fiscal Studies to overhaul the taxation of defined contribution pensions on death should not therefore come as a surprise.
The IFS report "Death and taxes and pensions" makes some punchy reform recommendations. Put forward under the guise of fairness, the proposals could in fact threaten to undo any progress made in encouraging people to save for retirement in recent years.
What is the current tax position of DC pensions on death?
In very broad terms, DC pensions are a workplace or personal pension scheme that an individual contributes to during their lifetime, topped up by contributions from their employer (if applicable).
The proposed changes can be expected to disincentivise people from making pension contributions.Upon death they are generally not subject to inheritance tax and if an individual dies before the age of 75, any residual funds in their pension can pass free of income tax to beneficiaries.
However, if an individual dies on or after their 75th birthday, any residual funds will pass to beneficiaries subject to each beneficiary's own marginal rate of income tax.
Change on the horizon
The two standout recommendations in the report include levying basic rate income tax on all funds that remain in DC pensions at death (irrespective of how old the individual is when they die) and including DC pension pots in the value of estates at death for the purposes of IHT.
The IFS says that subjecting DC pensions to IHT could potentially raise a further £1.9bn of IHT a year. If the government did not wish to increase the overall yield from IHT, the estimated additional yield would be enough to reduce the rate of IHT from 40 per cent to 30 per cent.
The IFS envisages that the changes would apply to everyone, including pensioners with already significant pension pots.
In pursuit of ‘fairness’?
According to the IFS, pensions are increasingly being used as a vehicle for tax-efficient bequests. The IFS seeks to back this up with figures demonstrating that pension contributions have increased over recent years (with the biggest increase seen in the 55 to 59 age category).
By removing the incentive to preserve retirement benefits, the IFS says that the tax system would be fairer and more economically efficient.
It should be noted that pensions already face restrictions.Pension contributions increasing should be seen as a positive. Encouraging people to save for retirement has been a major problem in the recent past and the proposals entirely neglect this.
The proposed changes can be expected to disincentivise people from making pension contributions.
It is less well-known that the eventual distribution of a DC pension is subject to an independent trustee’s discretion. The scheme trustee ultimately decides who inherits any pension on the death of the pension holder (although will be guided by – and will usually follow – an expression of wishes left by the holder).
This third-party discretion exempts DC pensions from IHT because the pension holder has no control over how their pension benefits pass on death. Subjecting DC pensions to IHT (at whatever rate) goes against the fundamental principles of IHT law.
It would represent a significant change in approach that could open the floodgates to other discretion-based situations that are currently free of IHT.
Should these changes be implemented, they won’t be well received.Although the current age 75 threshold is somewhat arbitrary, in today's world death before 75 would not be considered a particularly good innings (as acknowledged in the report). Granting families a bit of tax relief in these circumstances does not seem unreasonable.
Finally, it should be noted that pensions already face restrictions. Pension contributions (with the associated tax-free benefits) are subject to annual limits and withdrawals are subject to a lifetime allowance. Although a DC pension might be used to some degree to gain an IHT advantage, its use in the overall scheme of things is fairly limited.
What’s next?
The extent to which the IFS’s recommendations are absorbed is not yet known, but one thing we can be certain of is that, should these changes be implemented, they won’t be well received by either pension holders or the pension scheme businesses.
Matthew Peto is managing associate at Stevens & Bolton LLP
