The Institute for Fiscal Studies ("IFS") recently released a report titled "Death and taxes and pensions", which makes some fairly punchy reform recommendations relating to the taxation of defined contribution ("DC") pensions upon death.
What is a DC pension?
In very broad terms, DC pensions are a workplace or personal pension scheme that an individual contributes to during their lifetime, topped up by contributions from their employer (if applicable).
What is the current tax position of DC pensions on death?
The current tax treatment of a DC pension upon death can be summarised as follows:
- Not subject to inheritance tax ("IHT").
- If an individual dies before their 75th birthday, any residual funds in their pension can pass free of income tax to beneficiaries.
- If an individual dies on or after their 75th birthday, any residual funds in their pension will pass to beneficiaries subject to each beneficiary's own marginal rate of income tax.
A lifetime allowance ("LTA") charge of up to 55% can also be levied in circumstances where the LTA has been exceeded. The LTA is basically the maximum amount which can be withdrawn from a pension (during lifetime or following death) without suffering additional tax. The current LTA is set at £1,073,100, although certain individuals in the past may have been able to fix the LTA at a higher amount.
What changes have the IFS proposed?
The two standout recommendations in the IFS’s report (with the desired outcome of a fairer tax system) are to:
- levy basic rate income tax on all funds that remain in DC pensions at death (irrespective of how old the individual is when they die); and
- include DC pension pots in the value of estates at death for the purposes of IHT.
The IFS acknowledges that there would be a degree of retrospective taxation to the proposals. It is envisaged that the changes would apply to everyone, perhaps with a gradual phasing-in of the reforms, but pensioners who have already built up significant pension pots under the current rules would not be able to escape the proposed tax changes.
Why have the IFS suggested these changes?
According to the IFS, pensions are increasingly being used as a vehicle for bequests (i.e. it is better for an individual to leave their pension untouched until death as it is not subject to IHT). The IFS backs this up with some figures which demonstrate that contributions to pensions have increased over recent years (with the biggest increase seen in the 55 - 59 age category). By removing the incentive to preserve retirement benefits, the IFS says that the tax system would be fairer and more economically efficient.
Will the changes result in greater fairness?
Whilst advisers generally will view DC pensions as being very useful from an IHT planning perspective, it has to be questioned whether the changes will in fact bring about a fairer system.
I am very concerned that the proposed changes will disincentivise people from making pension contributions. Getting people to save for their retirement has been a major problem in the recent past and the IFS proposals run counter to saving for retirement.
Many may be unaware that a DC pension is subject to an independent trustee’s discretion (known as the scheme trustee). The scheme trustee ultimately decides who inherits any pension on death (although will be guided by – and will usually follow – an expression of wishes left by the pension holder). It is as a result of this lack of certainty that the pension is not subject to IHT, because the individual does not have control over how their pension benefits pass on death. This is a fundamental provision of the IHT rules and subjecting DC pensions to IHT would be a major change in approach.
Although the current age 75 threshold is somewhat arbitrary, in today's world death before 75 would not be considered a particularly good innings (the IFS acknowledges in its report that deaths before 75 are rare). Granting families a bit of tax relief in these circumstances doesn’t seem unreasonable to me.
Finally, and as alluded to above, there are already restrictions placed on pensions. Pension contributions (with the associated tax free benefits) are subject to annual limits, and withdrawals are subject to the LTA. Although a DC pension might be used to some degree to gain an IHT advantage, its use in the overall scheme of things is fairly limited.
It will be interesting to see how the IFS recommendations develop. If any of the changes are implemented, we can be reasonably confident that they won’t be well received either by pensioners or the pension schemes themselves.