Pensions as an Inheritance Tax Break

A new report from the Institute for Fiscal Studies (IFS) has claimed pensions are treated more generously by the tax system as a vehicle for inheritance than for retirement income. The IFS said that keeping savings in a pension tax wrapper can be a highly effective way of avoiding inheritance tax, and this is an anomaly that needs to be addressed. Their new “Death and Taxes and Pensions” study was funded by the Financial Fairness Trust and includes proposals to make the tax treatment of pensions on death fairer and more economically efficient. According to the IFS, the additional tax revenue generated by shifting to a different system could be substantial in the long term. The report said: “If the UK government did not want to raise the overall level of inheritance tax, then the revenue could be used to cut inheritance tax in ways that made the overall system fairer and more efficient. The report described the following problems with pensions: 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. More pension wealth is being passed down the generations due to growth in defined contribution pensions, the introduction of pension freedoms, and the substantial tax incentives for bequeathing pension wealth. The IFS wants pension pots to be included in the taxable value of estates on death, and therefore subject to inheritance tax. They argue that inheritance tax should apply equally across all forms of wealth. The body also wants basic-rate income tax to be charged on all funds that stay in pensions at death, or to see the current income tax rules extended to those inheriting pension pots from someone who dies before age 75. Isaac Delestre, author of the report, said: “Whether by accident, design or inertia, the tax treatment of pension pots at death has become increasingly eccentric. 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." By applying the recommendations in its report, the IFS believes it could raise around £1 billion a year in additional inheritance tax revenue, enough to reduce the rate of inheritance tax from 40% to 35% or to help fund the growing pressure on public services.

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