The Institute for Fiscal Studies (IFS) has set out "controversial" proposals to reform the pensions tax system, including reforming the 25 per cent tax-free component.
In a report, A blueprint for a better tax treatment of pensions, published today (February 6), IFS researchers suggested ways to even out tax support for pension saving – reducing subsidies where they are overly generous and increasing them where saving incentives are weaker.
The IFS said the current system of pensions tax does relatively little to support many of those facing low income in retirement, who most need it.
It argued that reducing limits on pension saving – the route taken in recent years – is not a good solution.
As part of the reforms, it suggested removing the 25 per cent tax-free component to provide a more equal subsidy to all private pensions, benefiting those with a low retirement income.
At present, people can take a quarter of their pension free of income tax.
While popular, the IFS said this provides a large tax subsidy to those with high incomes and big pensions but is of no value at all to those with the lowest incomes in retirement: non-taxpayers.
At a minimum, it said the tax-free component should be capped so that it only applies to 25 per cent of the first £400,000, for example, of accumulated pension wealth.
“This would still leave about four-in-five of those approaching retirement unaffected,” it said.
“Going further, we propose providing the equivalent of a capped 25 per cent tax-free component for basic-rate taxpayers, but designed in a way that increases the after-tax value of everyone’s pension (up to the cap) by the same proportion – basic-rate, higher-rate and non-taxpayers alike.
“A 6¼ per cent taxable top-up on all pension withdrawals would achieve this. There would be a case for providing a bigger top-up on withdrawals made via an annuity (which provides a secure retirement income) and a smaller one for other withdrawals.”
But Jason Hollands, managing director at wealth manager Evelyn Partners, argued these proposals could undermine faith in private pension saving.
He said: “People need to be encouraged to make appropriate provision if they want to avoid facing a steep decline in the living standards they have been used to when retiring.
“Our current system is certainly far from perfect, but regular tinkering has a corrosive effect on the savings impetus, giving the impression that the system is in flux. This risks undermining confidence in private pension saving as people fear that the goal posts will just keep getting moved.”
Hollands said that if a new pensions taxation system was being designed from scratch, it might not look like it does now, but that does not mean it can be easily improved or "made fairer" by piecemeal reforms.
He said: “A raid on the tax-free lump sum by capping it would be particularly unwelcome, especially by those who may have planned to use this for purposes like paying off a mortgage. Were such a policy to be implemented relatively quickly, it could leave retirement plans in a very difficult place.”
The lifetime and annual limits on the amount that can be saved free of income tax in a pension have been cut sharply since 2011, especially for the highest earners, raising taxes by an estimated £8bn a year.
The IFS said this has created complexity and damaging disincentives for an increasing number of higher earners.
It proposed that the government should:
Isaac Delestre, a research economist at the IFS and an author of the report, said pension saving is treated generously for high earners.
He said: "Our proposals would boost the retirement incomes of low and middle earners and provide greater encouragement for them to save more in a pension. They provide a coherent vision for the taxation of pensions and don’t require the complexity, and big losses for some current basic-rate taxpayers, that would result from restricting income tax relief to the basic rate, for which some have argued.
“This evening-out of tax support for pension saving would be more equitable and more economically efficient, and would allow the current set of poorly designed limits on what individuals can save in a pension to be relaxed."
Hollands said: “These measures as the IFS argues would, among other things, go some way to encouraging some older workers back into the workforce – something the UK needs right now,” he said.
Responding to the proposals, a HM Treasury spokesperson said: “We want to encourage pension saving to help make sure that people have what they need throughout retirement. That’s why, for the majority of savers, pension contributions are tax-free.
“And our reforms in 2010 to the annual allowance and lifetime allowance, which were necessary to deliver a fair system, only affect the wealthiest pension savers.”
The IFS also proposed that income tax should apply on withdrawals from inherited pensions regardless of the age of death and that pension pots - which at death are typically not counted as part of the deceased’s estate for inheritance tax purposes - should apply.
“We propose that if we are to have an inheritance tax, it should apply to all forms of wealth and therefore pension pots should be included in estates,” it said.
Tom Selby, head of retirement policy at AJ Bell, said the tax treatment of pensions on death is generous and, given how tight finances are at the Treasury, it would be no surprise if this came under the microscope.
Under former chancellor George Osborne the government scrapped the controversial 55 per cent ‘death tax’ on pensions.
“These new proposals from the IFS are not quite as pernicious, but come close to introducing a comparable penalty on death,” Selby said.
“Almost a decade on from Osborne’s reforms, the government might be tempted to turn back time to help rake in a little more cash for the Treasury coffers.
“If there were to be reform in this area, one of the big questions would be whether those who have contributed to a pension or made spending decisions in retirement based on the current system would be protected.”
Selby said without protection, the immediate moving of the tax goalposts would risk turning a sensible financial decision into one that costs people tens of thousands of pounds in tax.
Hollands said that levying inheritance tax on pension savings as well as income tax would turn people off pension reforms.
“IHT is already a very unpopular tax across almost all income and wealth cohorts. While the IFS might be seeking a sort of ‘uniformity’ by imposing IHT on all assets, it’s not entirely clear that this is a sensible step from where we are at the moment.
“It would for instance mean that bequeathed pension pots could first be taxed at 40 per cent on inheritance and then the remainder taxed at anywhere up to 45 per cent via income tax.
“Of course, the burden would not fall on the savers, but typically on their children and grandchildren who may not themselves be affluent at all.”
Other proposals by the IFS included giving up-front employee national insurance contributions (NIC) relief on all pension contributions, and tax pension income instead.
The IFS said while there is upfront income tax relief on pension savings, individuals do not get up-front relief from employee NICs on their own contributions.
It argued that up-front relief equivalent to the rates of employee NICs should be extended to all pension contributions and we should gradually move to a system where all private pension income is subject to employee NICs.
It also suggested decoupling the up-front tax subsidy from employer NICs.
The IFS said employer pension contributions escape employer NICs entirely and this is a huge tax break but is of no value when employers are not liable for employer NICs – for example, small employers.
It proposed applying employer NICs to employer pension contributions which would mean a new subsidy on all employer pension contributions could then be introduced.
It said: “Setting the new subsidy at 13.8 per cent would mean that no employer immediately lost from the reform. But a lower rate of subsidy would be possible. For example, a subsidy of 10 per cent would cost around £3.5bn a year less than a 13.8 per cent subsidy.”
Jon Greer, head of retirement policy at Quilter, said the current system of EET (exempt exempt taxed) is "merely tax deferral with the exception of tax-free cash".
"This is arguably ‘the’ tax break on pensions," he said. “Restricting TFC is perhaps a simpler proposal as you don’t get into tricky areas of double taxation,” he said. “However, the thought of restricting TFC will not be looked upon with the cold light of logic.
“It is emotive and always has been. Not a budget nears without at least rumours of TFC restrictions surfacing and that’s been the case every year since I joined the industry in 1998."
sonia.rach@ft.com
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