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Home Finance IFS report shows we need wholesale pension tax review

IFS report shows we need wholesale pension tax review

by uma


  • IFS believes the tax treatment of pensions means people could increasingly use them as an inheritance vehicle than for retirement income.
  • In 2010–12, defined contribution pension pots comprised of 15% of the wealth of those aged 45–59 whose total wealth exceeded £500,000 (in 2021 terms). By 2018–20, this figure had increased substantially to 24%.
  • This reflects not an increase in the average size of pension pots among this group, but rather a fall in their average level of non-pension wealth.
  • IFS recommends basic rate income tax be levied on all funds remaining in a pension on death. As it currently stands, if the person dies before age 75 the fund escapes income tax.
  • It also recommends pensions be included in the value of estates for the purposes of inheritance tax.
  • Such changes need to be considered carefully as part of a wholesale review of pension tax.

The Institute for Fiscal Studies have released a report on tax treatment of pensions on death: Death and taxes and pensions (ifs.org.uk)

Helen Morrissey, senior pensions and retirement analyst at Hargreaves Lansdown:

“The tax treatment of pensions on death is extremely generous – pensions escape inheritance tax while other types of assets do not – and where death occurs before the age of 75 there is no income tax to pay.

The IFS is right to point out such treatment may lead to behaviour where some people stockpile money in pensions and leave them untouched while drawing down on other assets. The report gives an example of a couple being able to pass on an estate of well over £3m inheritance tax free through the current system – it’s an extreme example but shows there are gaps in the system that could be exploited.

Applying basic rate income tax to all funds remaining in a pension on death, regardless of age, would apply across the board with even non-taxpayers, such as children, becoming liable – it’s certainly a better option than the 55% charge that used to apply where a pension had been accessed or death occurred post age 75.

The main benefit of reviewing and potentially reforming how pensions are treated on death is that it could incentivise people to use their pension to provide a secure lifetime income. It could also remove one reason for retaining the lifetime allowance.

We also need to consider whether these proposed changes become a hindrance to people trying to provide for their family. For instance, someone dying pre-age 75 could still have a young family to support and their pension could be viewed as life insurance rather than as an inheritance tax vehicle.

The report highlights the hugely complex world of pension tax and the importance of a wholesale look at how it is approached. For years we have seen a series of iterative changes – tweaks to lifetime and annual allowances for instance and these have caused problems and we need an overarching view to reduce the risk of unintended consequences. It is time for the issue of pension taxation to be reviewed wholesale rather than piece by piece.”