Should we allow drawdown to be used for IHT planning?
Pardon the Interruption
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Flexible drawdown has been the most popular retirement choice, but how big a role does the inheritance tax treatment of pension pots play in people’s choice – and is it a problem?
Drawdown is now far more popular than annuities for those coming up to retirement with a DC pot, but also for some people who have transferred out from DB. Although a majority withdraw their entire pot, recent data shows that a significant minority of pension plans accessed in 2018/19 entered income drawdown without being fully withdrawn (30%).
The main attraction of drawdown is that it gives access to a quarter of the pot tax-free. Research conducted by Ignition House for the Financial Conduct Authority in 2017 found that tax planning is a now key component of consumers’ decision making process.
However, despite consumers keen to access pensions untaxed, “there is evidence to suggest that our respondents did not completely understand the tax rules”, the paper noted. Few understood what happens to unused pots upon death and why pensions might be more favourable than other savings vehicles for inheritance tax planning, for example.
Pensions money is exempt from inheritance tax, although beneficiaries pay income tax if the deceased was over 75 years old. If the person was younger than that when they died, the pot can be passed on entirely tax free.
The average saver might be relatively clueless about inheritance tax rules, but this is not necessarily true for wealthier individuals – and certainly not for their advisers. Wealth advisers and insurers now advertise that they can help with ‘passing the pension fund through the family’ and provide guides on ‘passing on your pension wealth tax efficiently’.
Is IHT break on pensions luring people out of DB?
So how important was inheritance tax in the introduction of freedom and choice more than four years ago?
Malcolm McLean, a senior consultant at Barnett Waddingham, believes that the changes made to inheritance tax rules were an afterthought to the pension freedoms but now form an integral part of the policy.
McLean does not object to the inheritance tax treatment of drawdown per se but considers it a dangerous incentive for defined benefit members to cash out of their final salary schemes.
The tax treatment of pensions on death might be “one of the reasons why some people will choose drawdown instead of a final salary pension scheme, which could be a mistake as we know”, he said.
“If you wanted to do something about inheritance tax, there were other ways of dealing with it; you could have just simply increased the threshold, [or] you could have excluded certain categories,” he adds.
But a change to the current rules is unlikely, he says: “We are stuck with it now.”
Does the need for stability outweigh the issues with ‘generous’ IHT breaks?
For AJ Bell senior analyst Tom Selby, the tax treatment on death of pension pots forms part of the mixture of things that have made freedom and choice popular since the policy was introduced.
“The reality is for most people there will be a mix of factors which attract them to keeping their money invested in retirement, including flexibility in drawing an income, investment choice and tax treatment on death. It is the combination of these things which has driven the popularity of the pension freedoms reforms,” says Selby.
Selby says changing the tax treatment of pensions needs to be weighed against the need for stability to allow people to plan.
“The tax treatment of pensions on death is certainly generous, but the government needs to consider the negative impact tinkering could have on confidence in retirement saving,” he says.
As a starting point, Selby suggests the creation of an independent commission to review pension tax incentives. Such a review, he says, should focus on “simplifying the system and encouraging more people to save for their future”.
Low trust in pensions can lead to poorer outcomes for savers. In its Retirement Outcomes Review, the Financial Conduct Authority said that some retirees moved their entire pension into a savings account, “partly driven by a lack of trust in pensions, stemming from a range of factors including… frequent changes to pension rules and tax treatment”.
