Proposals from the Institute for Fiscal Studies (IFS) to shake up the current pension system have received mixed reviews from the industry.
The IFS has put forward a package of measures that would make taxation of pensions fairer to all savers, it said.
The proposals include a potential cap on the 25% tax-free lump sum people can take from their retirement pots from the age of 55.
According to the institute, the current system provides a “more generous rate of subsidy” to higher-rate taxpayers than to basic-rate ones. Something the IFS deemed “hard to justify” and in need of reform.
As a result, it proposed a cap to the sum the 25% can be applied to – up to the first £400,000 ($482,000, €46,560) of accumulated pension wealth.
The IFS added: “Going further, we propose providing the equivalent of a capped 25% tax-free component for basic-rate taxpayers, but designed in a way that increases the after-tax value of everyone’s pension (up to the cap) by the same proportion – basic-rate, higher-rate and non-taxpayers alike.
“A 6.25% taxable top-up on all pension withdrawals would achieve this. There would be a case for providing a bigger top-up on withdrawals made via an annuity (which provides a secure retirement income) and a smaller one for other withdrawals.”
Other measures included the application of income tax on withdrawals to inherited pensions, as well as counting pots as part of a person’s estate for inheritance tax (IHT) purposes.
Unsurprisingly, the proposals received a mixed bag of reactions, with some claiming the measures would be “deeply controversial” and disincentivise people from saving into a pension, while others believe the IFS’ proposed reform is “well balanced and thought through”.
Alice Guy, personal finance editor at Interactive Investor, said: “Capping the tax-free amount you can withdraw from your pension would be a serious disincentive to pension savers. The 25% tax free pension incentive is one of the best well known and best-loved pension rules. Encouraging people to save more for retirement is a battle for hearts and minds and slashing one of the most popular pension benefits could have a chilling effect on pension saving.
“We need to preserve confidence in the pension system. Millions of pension savers have built up pots under the current system and some could end up paying tax twice on the same pension savings, with the proposed changes.
“Saving for retirement is a marathon, not a sprint, and people take years to save enough for a comfortable retirement. Changing the rules half-way through is unfair on those who’ve saved on the basis on the current system. It means millions of Brits will suddenly need to save more for their retirement and their pension pot won’t stretch as far as they expected.
“There’s also a danger that widespread pension reform creates confusion and gives the impression that pensions are complicated and not for everyone.”
Jason Hollands, managing director at Evelyn Partners, added: “Our current system is certainly far from perfect, but regular tinkering has a corrosive effect on the savings impetus, giving the impression that the system is in flux. This risks undermining confidence in private pension saving as people fear that the goal posts will just keep getting moved.
“The taxation of pensions is just one component of the overall tax system, and so while higher earners undoubtedly gain a significant share of overall pension tax reliefs under the current system, it is also the case that they pay a huge slice of personal tax receipts, including 73% of all income tax. The tax system’s definition of ‘high earner’ is also getting alarmingly broad given frozen thresholds, with an estimated record 5.5 million paying 40% this tax year, a 15% increase in numbers over the prior year.
“A raid on the tax-free lump sum by capping it would be particularly unwelcome, especially by those who may have planned to use this for purposes like paying off a mortgage. Were such a policy to be implemented relatively quickly, it could leave retirement plans in a very difficult place.”
Hollands believes other types of reform should be prioritised, such as scrapping the tapered annual allowance, replacing the lifetime allowance and lifting the annual allowance levels.
“IHT is already a very unpopular tax across almost all income and wealth cohorts. While the IFS might be seeking a sort of ‘uniformity’ by imposing IHT on all assets, it’s not entirely clear that this is a sensible step from where we are at the moment.
“It would for instance mean that bequeathed pensions pots could first be taxed at 40% on inheritance and then the remainder taxed at anywhere up to 45% via income tax. Of course, the burden would not fall on the savers, but typically on their children and grandchildren who may not themselves be affluent at all.
“The effect could be to swing incentives towards spending pension pots early in retirement with unforeseeable consequences. It could also nudge people towards other tax-efficient ways to pass on wealth, like fuelling further investment into assets that attract business relief, such as AIM shares or enterprise investment schemes, which are not suitable for everyone.”
‘No silver bullet’
But Jon Greer, head of retirement policy at Quilter, and Tom Selby, head of retirement policy at AJ Bell, welcomed the IFS’ proposals.
Greer said: “On the surface of it, the proposals in the IFS report on pension taxation, out this morning, 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 (TFC). 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.
“But looking at the reality of it, you’d only save significant tax revenue if the change was applied to existing pension savings and that runs against the usual transitional protection that the Treasury usually apply. 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.
“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.”
AJ Bell’s Selby added: “The pension tax reforms set out by the IFS are balanced and well thought through. While often think-tanks will jump to radical proposals such as scrapping higher-rate pension tax relief in favour of a flat rate, the IFS rightly acknowledges this would create significant challenges, particularly for defined benefit (DB) schemes.
“Some of the ideas put forward here, in particular capping pensions tax-free cash, would be deeply controversial and risk a backlash of biblical proportions from voters. Others, such as making the tax treatment of pensions on death less generous, are potentially more doable but still come with challenges.
“The key, as the IFS acknowledges, is building a framework that is simple, provides savers with stability and maintains sufficient incentives necessary to ensure people save enough for later life.
“This need for stability is one of the reasons the idea of establishing a new pension tax commission, with a focus on simplification and encouraging more people to save for retirement, has appeal. Such a commission could potentially build the political consensus necessary to push through sensible, long-term reforms that can stand the test of time.
“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.
“This 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.”