- Pensions can be a very advantageous vehicle for bequests
- But changing that could push more people to take their tax-free cash lump sum
Tax advantages on inherited pension pots should be ended in order to stop people from using pensions as a way to avoid inheritance tax, according to a new report.
In its Death and taxes and pensions report published this month, the influential Institute for Fiscal Studies (IFS) think tank argued that the tax treatment of pension pots at death is "overly generous". Pension pots are currently exempt from inheritance taxation; additionally, if the holder dies before the age of 75, beneficiaries can draw from the pot free of income tax.
In contrast, pensioners themselves pay income tax when drawing income from their pots, regardless of their age. “Pensions are treated more generously by the tax system as a vehicle for bequests than they are as a retirement income vehicle,” noted the IFS, which called for both IHT and income tax to apply to pension pots at death.
The report added that pensions and wealth-management professionals are “fully aware” of these tax benefits, which encourage those who can afford to do so to draw pension income from other sources and keep their pension pot intact to pass on to their descendants. In the most extreme example, a married couple could each leave £1,073,100 in their pensions and escape a total IHT bill in the region of £600,000.
But others pointed out some of the drawbacks of the IFS proposal. “Changing the rules may have some unintended consequences,” said Jon Greer, head of retirement policy at Quilter. He argued that it might push people to take their tax-free cash lump sum earlier than planned, potentially reducing the amount they have available for retirement.
The change might discourage pensioners from keeping their pot invested, something that becomes increasingly important as more and more people rely on defined contribution rather than defined benefit pensions.
“Any changes would disproportionately impact unmarried couples, who are not entitled to spousal IHT exemptions and may have significant tax to pay on an inherited pension,” added Alice Guy, personal finance editor at Interactive Investor. It would also hit families who lose a loved one at a relatively early age, for whom the exemption from income tax can be an important support at a financially difficult time.
Greer also pointed to the fact that more and more people are paying inheritance tax one way or another. IHT receipts were at their highest level on record in 2021-22, both in nominal terms and as a percentage of GDP, partly due to the frozen IHT threshold.
However, the IFS report suggested revenue raised from pension pots at death could be used to either cut the IHT rate or increase the threshold.
