Pensions should be subject to tax on death, IFS says

Pensions should be subject to tax on death, IFS says

Anyone inheriting a pension should be subject to income and inheritance tax to change the “bizarre” tax treatment of retirement income, a new report has said.

The tax system treats funds that remain in a pension at the time of the owner’s death extremely favourably, the Institute for Fiscal Studies said today (December 15).

The IFS highlighted how the introduction of pension freedoms in 2015 will lead to more pension wealth being handed down at the point of death.

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“Pensions and wealth-management professionals are fully aware of these tax benefits,” it said.

“If nothing changes, more people will respond to the incentives the tax system creates.”

If an individual dies before the age of 75, any funds in their pensions are not subject to income or inheritance tax under current legislation.

The IFS has recommended that basic-rate income tax could be levied on all funds that remain in pensions when people die.

It also said pension pots should be included in the value of the owner’s estate for inheritance tax purposes.

If those funds are already subject to income tax, 80 per cent of their total value should be counted for inheritance tax purposes.

This would raise more revenue and remove the “perverse” incentive to avoid using a pension to fund retirement, it said. 

Short-term revenue would be limited because a small minority of those dying today are bequeathing pension pots, but this will change as those who benefitted from the pension changes in 2015 get older.

“If the generation benefiting from pension freedoms – those retiring after April 2015 – were to die with their full pension pots intact, we estimate that it would raise the equivalent of £1.9bn a year (in today’s terms) in extra inheritance tax revenue,” the IFS said.

The IFS said if the government did not want this change to increase the overall yield of inheritance tax, it could use the revenue to tax the inheritance tax rate or increase the threshold.

The £1.9bn that could be raised would be enough to reduce the rate from 40 per cent to 30 per cent, it said, while £0.9bn (the amount raised if half of current pensions were intact at death) would be enough to reduce the rate to 35 per cent.

These measures should be announced as swiftly as practical, the report said, in order to reduce the extent to which individuals saving in a pension are planning to bequeath it to their beneficiaries. 

Unintended consequences

Jon Greer, head of retirement policy at Quilter said these measures only make the situation ‘fairer’ for the exchequer, and not necessarily families especially those who may lose a loved one at a relatively early age where the financial impact can be significant.