A new report by the Institute for Fiscal Studies (IFS) entitled ‘Death and taxes and pensions’, also suggested basic-rate income tax could also be levied on all funds that remain in pensions at death. Subjecting pensions to inheritance tax would raise ‘substantial’ revenue for the Government over time and remove the ‘perverse incentive’ to avoid using a pension to fund retirement, they suggested.
If such proposals were to be adopted, it could mean many families lose an extra £60,000 to inheritance tax and income tax.
By changing the way pension pots are taxed at death, many more families will be forced to pay an even bigger bill upon the death of their loved one.
Someone inheriting a typical £100,000 pension pot from someone who had already used up their IHT allowances would lose £60,000 – because they would be hit by the 40 percent IHT charge as well as 20 percent on the pension pot itself if they were a basic-rate taxpayer, the Telegraph stated.
According to financial advice firm NFU Mutual, who ran the calculations, a beneficiary with income of £50,000 inheriting a £100,000 pension would pay an extra £44,974 in income tax that year as a result of the inheritance pushing them past the additional-rate threshold and because of the loss of the personal allowance.
Effectively, the £100,000 inherited pension could cost them £84,974 in inheritance and income tax.
READ MORE: 850,000 may see ‘immediate and painful’ mortgage increase as interest rate rises to 3.5%
If an individual dies before the age of 75, any funds in their pensions are not subject to income or inheritance tax under current legislation.
Their report said: “This results in the bizarre situation where pensions are treated more favourably by the tax system as a vehicle for bequests than they are as a retirement income vehicle.
“As such, there is a large incentive, for those who can, to use non-pension assets to fund their retirement while preserving their pensions for bequests.”
They explained if those funds are already subject to income tax, 80 percent of their total value should be counted for inheritance tax purposes.
This would raise more revenue and remove the “perverse” incentive to avoid using a pension to fund retirement, it said.
DON’T MISS
Short-term revenue would be limited because a small minority of those dying today are bequeathing pension pots, but this will change as those who benefitted from the pension changes in 2015 get older.
The IFS said: “If the generation benefiting from pension freedoms – those retiring after April 2015 – were to die with their full pension pots intact, we estimate that it would raise the equivalent of £1.9billion a year (in today’s terms) in extra inheritance tax revenue.
“This increase would be substantial, representing an increase of around a quarter in the scope and yield of inheritance tax.”
Jon Greer, head of retirement policy at Quilter, argued ending the tax treatment of pension pots on death on grounds of ‘fairness’ only makes the situation ‘fairer’ for the Exchequer, not necessarily families losing a loved one.
He said: ”Changing the rules may have some unintended consequences too, such as pushing people to take their tax-free cash lump sum earlier than perhaps they would ordinarily do so potentially reducing the overall amount they have available for retirement.
READ MORE: Millions on DWP benefits could get a £774 boost after court ruling
“In the grand scheme of things, the lost revenue to the Exchequer from this policy may not be significant compared to other areas of Government spending, but may have a very positive effect for a material number of families which are not high earners or fit into some of the extreme examples highlighted.
“The financial impact it might bring to some families of people who die early should not be discounted. I know that losing a loved one is already a difficult and emotional time and having to worry about the financial impact of that loss can add even more stress.
“The tax-free nature of a pension pot on death at earlier ages can provide some much-needed financial support for those families.”
The Government has frozen the inheritance tax (IHT) thresholds for two more years. As the threshold was already frozen until April 2026, it now means that the threshold is now frozen until April 2028 – netting the government a further £1 billion.
Additional changes to pensions could drag even more people into paying what is often touted as one of the nations most hated taxes.
Inheritance tax has become increasingly lucrative in recent years as soaring property prices and frozen tax allowances have pushed a growing number of families into the 40 percent net.
The Office for Budget Responsibility forecasts that the Treasury will raise a record-breaking £6.7billion from IHT this year.
Isaac Delestre of the IFS and author of the report said the tax treatment of pensions had become “increasingly eccentric” and these tax-efficiencies must be “swiftly ended”.
He 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.”
Express.co.uk has contacted the HM Treasury for comment.
