Yahoo Finance Pensions: The inheritance tax loophole authorities are desperately trying to close
Pensions are treated more generously by the tax system as a vehicle for bequests than they are for retirement income, the Institute for Fiscal Studies has said.
The economic research institute said in its new report that keeping savings in a pension can be a highly effective way of avoiding inheritance tax, and the sooner this anomaly is addressed the better.
Bequests are gifts that are made as part of a will or trust – it can be given to an individual, or it can be a charitable bequest to a non-profit organisation, trust or foundation.
The “Death and Taxes and Pensions” study, published on Thursday and funded by the abrdn (ABDN.L) Financial Fairness Trust, sets out proposals that would make the tax treatment of pensions at death fairer and more economically efficient.
The revenue raised by moving to a different system could be substantial in the longer term.
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“If the UK government did not want to raise the overall level of inheritance tax, then the revenue could be used to cut inheritance tax in ways that made the overall system both fairer and more efficient,” it said.
The report identified the following problems:
Inheritance tax. Any funds that remain in a pension at death (at any age) are not subject to inheritance tax. As such, there is a substantial incentive, for those who can, to use non-pension assets to fund their retirement while preserving their pensions for bequests.
To give the most extreme example: a married couple could each leave £1,073,100 in their pensions free of inheritance tax (i.e. £2,146,200 in total), whereas if they both bequeathed the same amount in other financial assets instead there could be a total inheritance tax bill approaching £600,000 (or more).
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Income tax. Pension contributions are already free from income tax, but usually money received from a pension is taxed instead. Income tax is payable on money received from a pension pot inherited from someone who died at or after age 75.
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But when someone dies before age 75, funds remaining in their pension escape income tax entirely. For a basic-rate taxpayer, the difference in income tax between inheriting a £100,000 pension pot from someone who died the day before they turned 75 and someone who died the day after turning age 75 would be £20,000.
For a higher-rate taxpayer receiving a £1,000,000 pension pot, this difference in income tax would rise to £400,000.
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Growth in defined contribution pensions, the introduction of ‘pension freedoms’ and the strong tax incentives described above all mean that more pension wealth is starting to be bequeathed.
The IFS is calling for pension pots to be included in the value of estates at death for the purposes of inheritance tax. If there is to be an inheritance tax, it should apply evenly across all forms of wealth, it argued.
Secondly, it is asking for basic-rate income tax to be levied on all funds that remain in pensions at death. Alternatively, current income tax rules could extend to those inheriting pension pots from someone who dies before age 75.
This would mean levying income tax when the person inheriting the pension pot withdraws the funds from it regardless of the age of death of the deceased.
In the longer term, if those benefiting from pensions freedoms were to leave half their pension pots intact at death, these changes could raise the equivalent of around £1bn a year in extra inheritance tax revenue.
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This would be enough to reduce the rate of inheritance tax from 40% to 35%. Or the funds raised could be used to help meet growing pressures on public services such as the NHS and adult social care.
“Whether by accident, design or inertia, the tax treatment of pension pots at death has become increasingly eccentric,” Isaac Delestre, a research economist at IFS and an author of the report, said.
“The coalition government missed the opportunity to fix the tax treatment of pensions at death when pension freedoms were introduced. It is not yet too late to act, but the longer the government delays, the more painful such reforms will become. Failure to embrace relatively small reforms now will leave a legacy for which the chancellor’s successors will not thank him."
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