Should you pay inheritance tax on pensions?

Pensions are one of the most tax-efficient ways of saving during your lifetime — and the tax perks continue after your death. They are not included as part of your estate and in most cases can be passed on free of inheritance tax (IHT), but with a new government needing to find ways to raise money, should this change?

David Sturrock from the Institute for Fiscal Studies, an economic research instituteAs long as inheritance tax exists it should apply equally to all forms of wealth. Otherwise people can avoid the tax by changing which type of assets they hold their money in and people with similar levels of wealth can end up with drastically different tax bills, making for an unfair system.

Pension pots typically sit outside an estate for IHT purposes. Until ten years ago this was not such an issue. Final salary pensions, which were more common, guarantee an income during your lifetime — there is no pot of money to leave when you die. Other types of pensions used to come with requirements to use the pension pot to buy an annuity (an insurance product that pays a regular income until you die) so pensions weren’t generally passed on to the next generation. For someone dying after 75, any funds left in a pension at death and eligible to be passed on were subject to a 55 per cent charge, intended to be equivalent to applying income tax and IHT.

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Since 2015 there has been no requirement to buy an annuity and no IHT applied to an inherited pension pot. In combination with the recent abolition of the lifetime allowance (which had limited how much could be accumulated into pensions while benefiting from income tax relief) pensions are now very effective vehicles for avoiding IHT. This has not gone unnoticed by financial advisers and money advice columnists who sometimes highlight the option of using other savings to fund retirement.

Imagine two single people who each die and leave a house worth half a million pounds, which they can leave to a direct descendant tax-free under the IHT rules. If one of them also has cash savings, each pound of those savings will have 40 pence taken in IHT. If the other person holds their savings in a pension pot, they can pass the lot on IHT-free. Why should the tax system treat these people differently?

A better way forward would be to bring pension pots into taxable estates, with an allowance to recognise the fact that income tax will usually be due on inherited pensions. If the government didn’t want IHT to be higher overall, it could use its revenue to reduce the IHT rate or increase the tax-free threshold. With more and more people retiring with substantial pension pots, it is important that they swiftly be returned to their original purpose: to fund retirement.

No

Daniel Herring from the Centre for Policy Studies, a centre-right think tankInheritance tax is already an unfair levy that does a lot of economic damage. Extending it to pensions would be an unprincipled money grab that will only compound tax avoidance by the wealthy, raise little revenue, and damage the economy further.

IHT is fundamentally flawed on economic grounds. It is damaging because money is not put to its most productive uses and it is so riddled with exemptions that the super wealthy avoid it easily while those with family homes are often hardest hit.

The main problem is that it distorts decision-making. As the Centre for Policy Studies has argued, the IHT rules do not encourage the efficient allocation of capital and this hurts everyone. When Sweden abolished IHT, it allowed family businesses to become much more entrepreneurial, as the tax no longer needed to be considered in investment decisions. Among the top challenges facing the UK is low investment, but our tax rules make effective investment harder.

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It’s also unlikely to raise much revenue. IHT is responsible for less than 1 per cent of revenue but takes up nearly 10 per cent of the tax legislation. As a country, we spend an enormous amount of money on lawyers and accountants to help us avoid paying IHT. It’s not hard to imagine that people will find ways to avoid paying tax on their pensions after they’ve died. And it’s important to note that the burden will continue to fall on the middle classes, because it is those who are very wealthy who can best dodge this tax.

By taxing pensions the government would also be preventing people from passing on the benefits of a lifetime of saving and hard work. It’s already the case that IHT, despite only applying to a small proportion of people, ranks as one of the UK’s most hated taxes.

About 50 per cent of people see it as unfair or very unfair, compared with just over 20 per cent who see it as fair or very fair, according to research by YouGov. It is seen as an unwanted and unjustified intrusion into family life, and this attitude would harden if pension savings, accumulated by discipline and thrift, were also to be liable for IHT.