Pensions are increasingly being used as an inheritance vehicle rather than for retirement income, a new report from the Institute for Fiscal Studies has revealed, avoiding tax.
The new report from the Institute, Death and taxes and pensions, on the tax treatment of pensions on death, highlighted that the tax system treats funds that remain in a pension at death “extremely favourably” and said growth in defined contribution pensions, along with the introduction of pension freedoms, has seen pensions increasingly being used as a vehicle for bequests rather than retirement income.
In 2010-12, defined contribution pension pots comprised 15% of the wealth of those aged between 45 and 49, whose total wealth exceeded £500,000. By 2018-20, this figure had increased substantially to 24%, reflecting 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.
The Institute has recommended that basic-rate income tax could be levied on all funds that remain in pensions at death and pension pots should be included in the value of estate at death for the purposes of inheritance tax. Currently, if the person dies before age 75, the fund escapes income tax.
The research think tank said that subjecting pensions to inheritance tax would raise an extra £1.9 billion a year in extra inheritance tax revenue and remove the incentive to avoid using a pension to fund retirement.
Helen Morrissey, senior pensions and retirement analyst at Hargreaves Lansdown, said: “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.
“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 is 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.”
However, Morrissey said a review would also need to consider whether these proposed changes become a hindrance to people trying to provide for their family.
Morrissey added: “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.”
