The Institute for Fiscal Studies has called on government to swiftly change tax rules for pension pots at death, saying they disincentivise people from using pensions to fund their retirement. 

 

Pensions are currently treated more generously by the tax system as a vehicle for bequests than they are as a retirement income vehicle, the IFS has said, which creates a “perverse incentive to avoid using a pension to fund retirement”. The institute said that “the sooner this anomaly is addressed, the better”. 

Independent adviser John Ralfe has said that the tax rules are not a coincidence but were a policy introduced by former chancellor George Osborne.
   

In a new report published on Wednesday together with the abrdn Financial Fairness Trust, ‘Death and Taxes and Pensions’, the IFS is proposing that pension pots should be included in the value of estates at death for the purposes of inheritance tax. Currently, any funds remaining in pensions are exempt from inheritance tax. Income tax is payable on money received from a pension pot inherited from someone who died at or after age 75, but not if they died younger. 

 

“If we are to have an inheritance tax, it should apply evenly across all forms of wealth,” the research organisation said. 

 
It also suggested that basic-rate income tax could be levied on all funds that remain in pensions at death, or that current income tax rules could extend to those inheriting pension pots from someone who dies before age 75. This means it would apply when the person inheriting the pension pot withdraws the money, regardless at what age the deceased died. 

 

In terms of revenue, taxing pensions more at death, “even if relatively modest in the near term, could be substantial in the longer term”, the institute said.  

 

If government didn’t want to raise the overall level of inheritance tax, then the revenue raised could be used to cut inheritance tax in ways that made the overall system fairer and more efficient, it added. 

 

Isaac Delestre, a research economist at IFS and an author of the report, called the tax treatment of pension pots at death "eccentric”.  

 

As the amounts held in defined contribution pensions increases, “the unfairness and inefficiency this bizarre tax treatment creates will only get worse”, Delestre 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,” he added. 

 

Mubin Haq, chief executive of abrdn Financial Fairness Trust, said the tax exemptions benefit mostly those with wealth. 

 

“Whilst this avoidance measure is open to all, it is the wealthiest in society who are set to benefit the most, escaping tax bills which for a couple could otherwise be around £600,000 or higher. Pension pots are there to fund retirement, and government must act to close this loophole,” said Haq. 

 

Do you agree that the tax treatment of pension pots at death needs to change?