Pensions in the UK are largely exempt from inheritance tax (IHT), especially defined contribution (DC) schemes, because pots currently do not form part of a person’s estate and are not factored in when calculating IHT liabilities.
But recent research from the Institute of Fiscal Studies (IFS) has suggested that the current system should be overhauled as retirees are increasingly looking to pass part of their pension pots on to their children and grandchildren.
Carl Emmerson, deputy director of the IFS, said that with DC schemes being IHT-exempt, beneficiaries managed to save thousands of pounds in tax on those ‘death benefits’. A tax treatment he claimed to be “indefensibly generous”.
“With inheritance tax, people sometimes complain of double taxation,” he said. “With this, there’s no taxation,”
Emmerson added that, by being IHT exempt, the system is “incentivising pension pots to be used as inheritance vehicles rather than for their traditional purpose of providing a retirement income”.
Before and after 2015
Steve Webb, partner at LCP, told International Adviser that this was not always the case. Up until then chancellor George Osborne changed the pension rules, retirees who died over the age of 75 and had not drawn money from their DC pot were subject to a 55% tax charge.
He said that this was a way to ‘claw back’ the tax relief received on contributions as the money ended up not being paid as a pension. As a result, it was quite rare that retirees over the age of 75 left their pensions intact.
But when Osborne changed the rules, it meant that people were able to save into a pension, get tax relief on those contributions, leave the pot untouched to then be passed on, tax-free, to their beneficiaries on death.
Webb said: “The favourable tax rules introduced by George Osborne make pension savings more attractive than Isas or other savings when it comes to tax on death. Critics point out that tax relief on pension contributions is given to help people build up a pot of money to be used for their retirement rather than build up a pot which can be passed on outside the inheritance tax system.
“Indeed, there is now an incentive for people to run down Isas in retirement before pensions because Isas would count as part of someone’s estate. The Treasury must be eyeing up this tax break with great interest, but abolishing it overnight would be controversial as growing numbers of people will have made financial decisions based on the existing rules.
“This is another reason why long-term stability in the rules around pension tax relief would be a good thing.”
Constraint on pension freedoms?
But if chancellor Rishi Sunak does end up turning the system upside down in his upcoming budget on 27 October, the move would be “at the extreme end of the spectrum of wealth tax reform”, Steven Cameron, pensions director at Aegon, told IA.
“It would have a multitude of knock-on consequences potentially for millions of people, and in many ways would go against core pension policy objectives of encouraging people to save adequately for retirement, with the freedom to use their accumulated funds flexibly throughout retirement.
“When saving in a pension, the vast majority of people are doing so to provide an income for themselves, and a partner, in retirement, rather than passing on an inheritance. So, bringing accumulated pension funds or ‘death benefits’ into an individual’s taxable estate on death would seem particularly harsh and unjustified.
“We need to encourage more people to save more into pensions, and creating a possible tax liability for ‘good behaviour’ would be highly counterproductive. Since the pension freedoms were introduced around six years ago, an increasing number of individuals with DC pensions are deciding against using their pot to purchase an annuity and instead to keep the fund invested and ‘draw down’ a flexible income.
“Under drawdown, funds remaining on death can be passed to a beneficiary free of IHT although on death after age 75, beneficiaries pay income tax on any income taken. But changing the rules here and making any remaining funds on death subject to IHT would also encourage individuals to avoid leaving money in their fund and instead to take more income sooner, increasing the risk of them running out of money while still alive and well.
“This would undermine the whole concept of pension freedoms. Such a change could also limit ways of funding in advance for an individual’s share of possible future social care costs. One option would be for individuals who opt to keep their DC pension invested and draw down from it, to notionally ringfence – and leave untouched – part of their drawdown fund in case they need it for social care.
“But the prospect of IHT on any remaining funds would make this far less attractive,” Cameron added.