Uncertainty over death and taxes?

Shortly before Christmas the IFS released its report Death and taxes and pensions with the headline view that taxation of pensions on death is far too generous.

Much as we’d all like lower taxes and to leave more to our loved ones, I think it’s pretty hard to disagree with this assessment. When pension freedoms came into force, significant changes to the taxation of death benefits were also introduced. Even at the time these seemed overly magnanimous and when announced had come as a surprise as the changes weren’t anything the industry was calling for.

The ability to leave funds to any beneficiary within a pension wrapper as opposed to just a dependant was welcome. Previously the only option for non-dependants was a lump sum – tax free if the deceased was under 75 and hadn’t accessed benefits – but otherwise subject to tax at 55%. Making it completely tax free on death before age 75 regardless of access, and taxable only as income thereafter was a bonus no one had been expecting. And of course, in most circumstances pensions are outside the estate for IHT.

The IFS reports that these tax changes have influenced behaviour. And while there will be plenty that use their pension as intended by government (to fund their retirement), I’m sure many of you will have had conversations with clients approaching retirement about using other assets first and touching the pension last.

So by creating an incredibly tax-efficient way of passing funds down the generations, it is no surprise that behaviour has changed, and the wealthy are leaving substantial pots untouched on their death.

Of course, the problem with making any changes to taxation on death now is that many thousands have built up pensions – and/or reduced the rate of withdrawals – based on current tax policy.

If the government followed the IFS’s recommendations and introduced not just Income Tax on all death benefit payments (and I mean all – the suggestion is for even non-taxpayers to pay at least basic rate tax on income from beneficiary’s drawdown) but also made pensions chargeable to IHT, then there would be many who may feel justifiably aggrieved.

We know that in the past when big changes to taxation of pensions have come in then protection has usually been on offer to some degree or another – but do we really want yet more complexity in our pension system? Instead the IFS suggest a transitional period where both Income Tax and IHT are phased in by date of death but given the recommendation is only a five year time period the relief this will give would be minimal.

On a more positive note, if the changes came in the process for paying out death benefits could be simplified, with no need for the scheme administrator to exercise discretion, and the removal of ambiguity around tax treatment on transfers of pensions in ill health.

The report may come to nothing in respect of policy changes, but it’s sure to at least stir the pre-Budget rumour mill.