The Institute for Fiscal Studies (IFS) is urging the government to scrap the 25% tax-free lump sum in a report published today (6 February), which also suggests including pension pots in the inheritance tax net.
In the report, titled A blueprint for a better tax treatment of pensions, the IFS has suggested that the 25% tax-free component needs reform, the EEE employee National Insurance Contributions (NICs) treatment of employer pension contributions should be ended and the EEE employer NICs treatment of employer pension contributions should also be ended.
AJ Bell head of retirement policy Tom Selby said: “The pension tax reforms set out by the IFS are balanced and well thought through. While often think tanks will jump to radical proposals such as scrapping higher-rate pension tax relief in favour of a flat rate, the IFS rightly acknowledges this would create significant challenges, particularly for defined benefit (DB) schemes.
“Some of the ideas put forward here, in particular capping pensions tax-free cash, would be deeply controversial and risk a backlash of biblical proportions from voters. Others, such as making the tax treatment of pensions on death less generous, are potentially more doable but still come with challenges.
“The key, as the IFS acknowledges, is building a framework that is simple, provides savers with stability and maintains sufficient incentives necessary to ensure people save enough for later life.
“This need for stability is one of the reasons the idea of establishing a new pension tax commission, with a focus on simplification and encouraging more people to save for retirement, has appeal. Such a commission could potentially build the political consensus necessary to push through sensible, long-term reforms that can stand the test of time.”
Selby argues that any attempt to limit tax-free pension payments or eliminate them runs the risk of eroding the flimsy savings culture being established by automatic enrolment. He anticipates that it won’t be well received at all.
Selby said: “It is far from clear how the transition from the current system to a reformed one would work in practice. Those who have built up pensions under the existing system would, presumably, have any tax-free entitlement honoured if the UK were to shift to an alternative framework.
“This would inevitably mean creating a complex set of rules whereby those who have pensions already have that tax-free cash entitlement ringfenced, with new contributions moving to a different set of rules.
“It would therefore risk not only discouraging retirement saving but layering on additional complexity that would remain in the system for decades.”
According to Selby, one of the key concerns, if tax-free death benefits of drawdown for deaths before age 75 were scrapped and pensions were brought into the scope of IHT, would be whether those who have made retirement spending decisions or pension contributions would be protected. Without protection, the quick shifting of the tax goalposts runs the possibility of making someone pay tens of thousands of pounds in additional taxes as a result of a prudent financial choice. He argues that those who would feel as though a retrospective tax adjustment has resulted in a massive tax burden would feel quite wronged.
Selby added: “Creating a new protection regime – as we have seen when the lifetime allowance has been cut previously – would layer additional complexity onto an already difficult-to-navigate system and limit the amount of cash such a move would raise.
“Any move to levy a new pensions death tax would also be politically risky, and politicians would inevitably face a significant backlash from savers and retirees ahead of the general election.
“In terms of the financial decisions people make, the most obvious consequence of increasing taxation on death would encourage more people to spend their pension pots during their lifetime. As things stand, it can often be sensible to spend your non-pensions assets first in order to minimise the IHT your beneficiaries will pay on death.”
“If the Treasury is lining up pensions for a tax raid at the upcoming Budget, there is an argument levying National Insurance on employer contributions is one of the less painful ways to raise some much-needed cash.
“It would certainly be preferable to anything which undermines the retirement saving incentives of individuals, such as capping tax-free cash or ditching higher-rate relief.
“The big stumbling block here would be the extra cost it would load on businesses at a time when the UK is teetering on the brink of recession. Given the Government’s desperate desire to spur growth in any way possible, it seems unlikely an effective hike in businesses’ NI will gain much traction.”
“It is something of an anomaly of the UK tax system that pensioners do not pay National Insurance contributions. After all, older people are more likely to rely on public services like the NHS – so, theoretically at least, it would make sense for them to help fund those services by paying NI in the same way working people do.
“While the theory of charging NI on pension income might be sound, it is hard to imagine a situation, in the short-term at least, where a Government feels it can go down this road without sparking fury among older voters.
“Given the proximity to a general election, hiking NI for pensioners is probably towards the bottom of both Rishi Sunak and Keir Starmer’s current to-do lists.”
Evelyn Partners managing director at wealth manager Jason Hollands believes that the proposals could undermine faith in private pension saving at a time when the retirements of most of today’s workers need to be better funded.
He said: “People need to be encouraged to make appropriate provisions if they want to avoid facing a steep decline in the living standards they have been used to when retiring. Our current system is certainly far from perfect, but regular tinkering has a corrosive effect on the savings impetus, giving the impression that the system is in flux. This risks undermining confidence in private pension saving as people fear that the goalposts will just keep getting moved.”
“The taxation of pensions is just one component of the overall tax system, and so while higher earners undoubtedly gain a significant share of overall pension tax reliefs under the current system, it is also the case that they pay a huge slice of personal tax receipts, including 73% of all income tax. The tax system’s definition of ‘high earner’ is also getting alarmingly broad given frozen thresholds, with an estimated record 5.5 million paying 40% this tax year, a 15% increase in numbers over the prior year.
“A raid on the tax-free lump sum by capping it would be particularly unwelcome, especially by those who may have planned to use this for purposes like paying off a mortgage. Were such a policy to be implemented relatively quickly, it could leave retirement plans in a very difficult place.
“A scrapping of the tapered annual allowance would be welcomed, however, as would a replacement of the lifetime allowance and the potential lifting of the annual allowances whose real values have been dramatically eroded by both nominal cuts and the effect of inflation. These measures as the IFS argues would, among other things, go some way to encouraging some older workers back into the workforce – something the UK needs right now.”
Inheritance tax (IHT) is already an extremely unpopular tax across practically all income and wealth groups, he continues, so adding it to income tax on pension funds will discourage people from supporting pension changes. Although the IFS may be attempting to achieve some ‘uniformity’ by imposing IHT on all assets, it’s not totally obvious that this is a reasonable next step from where we are right now.
He said: “It would for instance mean that bequeathed pensions pots could first be taxed at 40% on inheritance and then the remainder taxed at anywhere up to 45 per cent via income tax. Of course, the burden would not fall on the savers, but typically on their children and grandchildren who may not themselves be affluent at all.
“The effect could be to swing incentives towards spending pension pots early in retirement with unforeseeable consequences. It could also nudge people towards other tax-efficient ways to pass on wealth, like fuelling further investment into assets that attract Business Relief, such as AIM shares or Enterprise Investment Schemes, which are not suitable for everyone.
“Another measure unlikely to be well received would be the application of National Insurance Contributions on pension withdrawals, a de facto tax rise on retirees. In theory, National Insurance is a levy to qualify for the state pension and other benefits, so having to continue to pay in at the time of actually receiving the benefit may seem illogical.”