Pension pots should be subject to inheritance tax and new limits imposed on tax-free lump sum withdrawals to “even out” tax support for retirement saving, an influential think-tank has said.
Employees and employers receive tax breaks on income tax and National Insurance respectively, as well on inheritance tax, to create incentives to contribute to retirement schemes. About £115bn a year is saved into workplace pensions in the UK.
But the Institute for Fiscal Studies believes more could be done to support many people facing low income in retirement, “who most need it.”
“The current system of pensions tax provides overly generous tax breaks to those with the biggest pensions, those with high retirement incomes and those receiving big employer pension contributions,” said the IFS.
In a report published on Monday, the IFS set out a range of policy measures to “even out” tax support for pension saving such as “reducing subsidies where they are overly generous and increasing them where saving incentives are weaker”.
One of the key proposals is to make the 25 per cent pension tax-free lump less generous. Over-55s can withdraw a quarter of their pension pot without paying income tax on the money.
“While popular, 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,” the IFS said.
“At a minimum, the tax-free component should be capped so that it only applies to 25 per cent of, say, the first £400,000 of accumulated pension wealth: this would still leave about four in five of those approaching retirement unaffected,” it added.
Jason Hollands, managing director at Evelyn Partners, the wealth manager, said a raid on the tax-free lump sum would be “particularly unwelcome”, especially for those who may have planned to use it to help pay off a mortgage.
“Were such a policy to be implemented relatively quickly, it could leave people in a very difficult place,” said Hollands.
The IFS also believes reforms are needed to stop pensions being employed as an “easy-to-use vehicle for avoiding inheritance tax” and wants income tax charged on inherited pension funds.
Andrew Tully, technical director with Canada Life, a pension provider, said including pensions within the IHT environment would be “hugely unpopular” at a time when IHT is already hitting many more people.
“It also risks changing behaviour and not generating much in the way of tax as wealthier people ‘rearrange the deck chairs’ by removing money from the pension environment and shelter it from IHT in other ways, such as under trust,” he added.
The IFS proposed that employees get relief from national insurance contributions on their pension contributions, as well as income tax relief. However, in return, it said pensioners should pay NICs on their private pension income — a move that would have an impact on higher-rate taxpayers enjoying larger employer pension contributions.
“While the theory of charging NI on pension income might be sound, it is hard to imagine a situation, in the short term at least, where a government feels it can go down this road without sparking fury among older voters,” said Tom Selby, head of retirement policy at AJ Bell.
The IFS believes these reforms will enable the Treasury to be “more relaxed” about increasing the limits on both the annual and lifetime allowances, both of which have been subject to a series of cuts over the past decade. The policy of tapering the annual allowance for the very highest earners should also end, it said.
Sir Steve Webb, a former pensions minister, said there was “no doubt” the current pension tax system was “complex, sometimes arbitrary and has suffered from piecemeal reforms over a decade or more”.
But he warned against reforms that could amount to retrospective taxation as savers suddenly found “their careful financial plans no longer added up because of a last-minute change to rules around income tax and NICs”.
“Whilst ‘fiscal purity’ is admirable, a long list of complex reforms implemented over a period of decades is not what pension savers need right now,” said Webb, a partner at pension consultants LCP.