The Institute for Fiscal Studies today released a number of proposals for the reform of pensions taxation, including scrapping the 25% tax-free lump sum and bringing pension pots under the scope of inheritance tax.
Jason Hollands, Managing Director at wealth manager Evelyn Partners, says 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: “People need to be encouraged to make appropriate provision 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 goal posts will just keep getting moved.”
Hollands says that if you were designing a pensions taxation system from scratch, it might not look like it does now, but that doesn’t mean it can be easily improved or ‘made fairer’ by piecemeal reforms.
“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.
He adds that levying inheritance tax on pension savings as well as income tax would turn people off pension reforms: “IHT is already a very unpopular tax across almost all income and wealth cohorts. While the IFS might be seeking a sort of ‘uniformity’ by imposing IHT on all assets, it’s not entirely clear that this is a sensible step from where we are at the moment.
“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% 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.”