This would mean a pension pot worth £1million would be hit by £520,000 in inheritance tax and income tax, according to a report by the Institute for Fiscal Studies (IFS). The changes could raise up to £1.9billion a year in inheritance tax, which would be enough to reduce the rate of inheritance tax from 40 percent to 30 percent, the study said.
At present, if a person dies before the age of 75, their successor will not pay income tax on the payments they receive from their private pensions, and Britons get tax relief when they pay into their pension.
Funds inherited in a pension also avoid inheritance tax, a hefty 40 percent tax that applies to other assets worth a total of more than £325,000 for single people or £650,000 for couples.
The IFS has said this creates a “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”.
To address this, the group has suggested levying the basic rate of income tax, which is currently 20 percent, on all withdrawals from an inherited pension fund, regardless of the age of the person when they died.
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The institute said this could be combined with a minimum rate of income tax on withdrawals, to prevent funds avoiding the tax if they are being withdrawn by non-income taxpayers, such as children.
The group is also proposing extending inheritance tax (IHT) to pension pots, with 80 percent of their value to be hit by IHT, if they were also made subject to the basic rate of income tax.
Under the proposals, the taxation from IHT and income tax on inherited pensions would equate to:
- £100,000 pension pot – £52,000 in taxes
- £250,000 pension pot – £130,000 in taxes
- £500,000 pension pot – £260,000 in taxes
- £1million pension pot – £520,000 in taxes.
The IFS estimates if the generation set to benefit from the current pension tax freedoms – those retiring after April 2015 – were to die with their pension pots full, this would generate £1.9billion a year in IHT receipts.
The analysts said this would represent a 25 percent increase in IHT revenue, justifying a reduction of the IHT rate from 40 percent to 30 percent.
If this generation died with half of their current pensions in tact, this would boost IHT receipts by £0.9billion, enough to reduce the rate to 35 percent.
Tom Selby, head of retirement policy at AJ Bell, said the “generous” tax treatment on death for pensions may be reassessed by the Government ahead of next year’s Budget.
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He warned: “Without protection, the immediate moving of the tax goalposts would risk turning a sensible financial decision into one that costs people tens of thousands of pounds in tax.
“Those facing a colossal tax bill as a result of what would feel like a retrospective tax change would understandably feel extremely hard done by.
“However, creating a new protection regime – as we have seen when the lifetime allowance has been cut previously – would layer additional complexity onto an already difficult to navigate system and limit the amount of cash such a move would raise.”
In addition to the £325,000 and £650,000 nil-rate bands for inheritance tax, Britons can also get a £175,000 residence nil-rate band for passing on their home, bringing the tax-free allowance for couples to £1million.
People can also reduce the IHT rate applying to their estate to 36 percent, if they leave at least 10 percent of their estate to charity.
The 36 percent rate is applied to the rest of a person’s estate after the amount going to charity has been deducted.