Pensions should be subject to tax on death, IFS says

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.

“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 the generation benefiting from pension freedoms were to die with their full pension pots intact, it would raise the equivalent of £1.9bn a yearIFS

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 tax-free nature of a pension pot on death at earlier ages can provide some much-needed financial supportJon Greer, Quilter

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.

“The tax-free nature of a pension pot on death at earlier ages can provide some much-needed financial support for those families [who have lost a loved one],” he said.

Changing the rules may have some unintended consequences too, Greer added, 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.”

He highlighted the extra £1bn the government will be receiving from the freezing of IHT thresholds for a further two years in the Autumn Statement. 

“These additional changes to pensions would drag even more people into paying what is often touted as one of the nations most hated taxes.

Retirement outcomes are currently being compromised by a lack of understanding about pensionsAlice Guy, Interactive Investor

“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.”

Alice Guy, personal finance editor at Interactive Investor, said the report was “strong stuff” and the content will be up for debate. 

“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, she added, whereas defined benefit pensions with survivor benefits would not be impacted by a rule change.

"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.”

sally.hickey@ft.com