The Institute for Fiscal Studies has set out a series of proposals to reform the pensions tax system, including overhauling the 25% tax-free lump sum.
In its report ‘A blueprint for a better tax treatment of pensions’ published on 6 February 2023, the think-tank said the current pensions system does little to support the retirement income of low and middle earners while providing “overly generous” tax subsidies to those who are not in danger of undersaving for retirement.
At present, pension savers can take a quarter of their pension free of income tax. However, the IFS said that this provides a more generous rate of subsidy to those who are higher-rate taxpayers than those who are basic-rate taxpayers and is of no value to non-taxpayers.
At a minimum, the IFS has proposed that the tax-free lump sum be capped so that it only applies to 25% of the first £400,000, for example, of accumulated wealth.
Going further, it proposes introducing the equivalent of a capped 25% tax-free component for basic-rate taxpayers but designed in way that increases the after-tax value of everyone’s pension by the same proportion – basic-rate, higher rate and non-taxpayers alike. It says a 6 ¼ taxable top-up on all pension withdrawals would achieve this.
Jon Greer, head of retirement policy at Quilter, said: “On the surface of it, the proposals in the IFS report on pension taxation will almost certainly elicit some consternation from the industry and public. But regardless of whether people agree or disagree with the proposals they certainly take pension taxation in a different direction and this should be welcomed.
“The paper discusses restricting tax-free cash. 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. Restricting TFC is perhaps a simpler proposal as you don’t get into tricky areas of double taxation. 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.”
Greer said that in reality, the government would only save significant tax revenue if the change was applied to existing pension savings, which would run against the usual transitional protection applied by the Treasury.
Greer continued: “If government applied it retrospectively there would be such a backlash that the Conservatives would unlikely be re-elected for some time. You could even go as far to suggest that the government might be subject to claims of human rights infringements. People would likely feel that an unwritten pact had been broken and it could seriously damage the reputation of pensions.
“If you did tax some element of the lump sum going forward it is presumably the case that this could, for some people, put a basic rate taxpayer in retirement into higher rate tax. PAYE tax on flexible withdrawals especially lump sums is already a difficult area for customers to comprehend.”
Tom Selby, head of retirement policy at AJ Bell, warned that a move to reform the tax-free lump sum – arguably the one area of pensions most people understand – could undermine pension saving.
He said: “The ability to access 25% of your pension tax-free is one of the few parts of the retirement system that the majority of people both understand and value. As such, any move to remove or cap the available tax-free cash would risk undermining the fragile savings culture being built under automatic enrolment. It would also be deeply unpopular – a key factor given a general election is drawing near.
“It is far from clear how the transition from the current system to a reformed one would work in practice. Those who have bult up pensions under the existing system would, presumably, have any tax-free entitlement honoured if the UK were to shift to an alternative framework.”
Selby said it would inevitably mean creating a complex set of rules whereby those who have pensions already have that tax-free cash entitlement ringfenced, with new contributions moving to a different set of rules.
“It would therefore risk not only discouraging retirement saving but layering on additional complexity that would remain in the system for decades,” he added.
National Insurance Contributions relief
The IFS has proposed that the current employee National Insurance Contributions (NIC) relief on pension contributions should be ended and replaced with a system that allows all individual pension contributions to receive up-front relief equivalent to the rate of employee NICs. Gradually, the system should move to one where pension withdrawals are subject to employee NICs.
The IFS argues that this approach would align the employee NICs treatment of pension saving with that of income tax.
It has also called for the employer NICs treatment of employer pension contributions to be abolished.
Commenting on the proposals, Selby said: “If the Treasury is lining up pensions for a tax raid at the upcoming Budget, there is an argument that levying National Insurance on employer contributions is one of the less painful ways to raise some much-needed cash.
“It would certainly be preferable to anything which undermines the retirement saving incentives of individuals, such as capping tax-free cash or ditching higher-rate relief.
“The big stumbling block here would be the extra cost it would load on businesses at a time when the UK is teetering on the brink of recession. Given the Government’s desperate desire to spur growth in any way possible, it seems unlikely an effective hike in businesses’ NI will gain much traction.”
Scrap death benefits
In its report, the IFS says the tax system is currently more generous for the use of pensions as a vehicle for bequests rather than a vehicle for retirement income.
As it stands, when an individual dies before age 75, funds that remain in a pension escape income tax entirely. The IFS has proposed that income tax should apply on withdrawals from inherited pensions regardless of the age of death and that pension pots, which are not typically counted as part of the deceased’s estate for inheritance tax purposes, should become subject to IHT.
“Together, these measures would raise additional revenue, with the inheritance tax change in particular falling predominantly on wealthier individuals and their heirs. If the Government did not want to increase inheritance tax overall, it could use the revenues raised from that measure to reduce the inheritance tax rate or increase the threshold,” it said in its report.
Selby said that as the Government seeks to raise more cash, it would be “no surprise” if this came under the microscope.
Under former Chancellor George Osborne the Government scrapped the controversial 55% ‘death tax’ on pensions.
While these new proposals from the IFS are “not quite as pernicious”, according to Selby, they come close to introducing a comparable penalty on death.
He 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. 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. Those facing a colossal tax bill as a result of what would feel like a retrospective tax change would understandably feel extremely hard done by.”
Selby said that by creating a new protection regime would layer additional complexity onto an already difficult-to-navigate system and limit the amount of cash such a move would raise.
Lifetime Allowance limit
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, raising an estimated £8 billion a year for Government coffers.
The IFS said that implementing its proposed rules would allow the government to be more relaxed about pension limits.
“We propose that as part of this package of reforms, pension limits should be redesigned, with distinct approaches for defined benefit and defined contribution arrangements. For DB arrangements, it would make sense to use regulation to place a cap on the pension benefits. For DC arrangements, we proposed replacing the current lifetime allowance with a lifetime contribution cap. This would have the advantage of not distorting the investment decisions of those with large pension pots,” it said in its report.
This restructuring of lifetime limits could also be coupled with an increase in their generosity, with a stronger case for a substantial increase in the annual allowance and the policy of tapering the annual allowance for very high earners scrapped.
Greer added: “Ultimately changing the current regime isn’t easy because there is no silver bullet to fix all the problems but radical ideas are never easy to stomach and while many of the proposals may have some tricky practical application and perhaps some unintended consequences we need to have these conversations as they move the debate forward on an issue that will have a profound impact on the fortunes of the generations to come.”
