There’s no doubt the tax treatment of pensions on death is extremely generous – pensions escape inheritance tax while other types of assets do not, and where death occurs before the age of 75 there is no income tax to pay.
These benefits were the subject of a recent report from the Institute of Fiscal Studies, which pointed out such treatment may lead to behaviour where some people stockpile money in pensions and leave them untouched while drawing down on other assets.
The report gives an example of a couple being able to pass on an estate of well over £3mn IHT free through the current system if they utilised current pension rules and made full use of their inheritance thresholds.
It’s an extreme example but shows there are gaps in the system that could be exploited and points to instances where pensions are not being used for their primary purpose – to give an income in retirement.
According to the report in 2010-12, defined contribution pension pots comprised 15 per cent of the wealth of those aged 45–59 whose total wealth exceeded £500,000 (in 2021 terms).
However, by 2018-20 this figure had increased substantially to 24 per cent. This reflects not an increase in the average size of pension pot among this group, but rather a fall in their average level of non-pension wealth, so could indicate that wealthier people are favouring their pensions over other savings vehicles.
The IFS proposed applying basic rate income tax to all funds remaining in a pension on death, regardless of whether death occurs before or after age 75.
This would apply across the board and include children inheriting pensions. It’s certainly a better option than the 55 per cent charge that used to apply where a pension had been accessed or death occurred post age 75.
It also proposed that pensions be included in estates for IHT purposes.
Such a move would certainly prompt more people to access their pensions but looking more widely could prove problematic.
The main benefit of reviewing and potentially reforming how pensions are treated on death is that it could incentivise people to use their pension to provide a secure lifetime income.
It could also remove one reason for retaining the lifetime allowance, something which would no doubt bring great cheer across the pension industry and much needed simplification to a hugely complex tax system.
However, we also need to consider whether these proposed changes become a hindrance to people trying to provide for their family.
While it’s fair to say some people are using their pensions as a way of passing down assets free of IHT this certainly isn’t the case for everyone.
For instance, someone dying before age 75 could still have a young family to support and in this case their pension could be viewed as life insurance rather than as an IHT vehicle.
