Independent economics researcher the Institute for Fiscal Studies (IFS) has published its Blueprint for a better tax treatment of pensions. This identifies differing wealth and pension provision for today’s workforce compared with those born before the 1960’s and suggests fundamental reforms of pension taxation are needed to address these issues, whilst balancing the cost of tax reliefs associated with pensions.
Tax policy can affect people’s attitudes and approach to saving into a pension. For instance, under current rules:
- contributions to pension schemes commonly attract tax relief,
- investment growth within a pension fund is not taxable, and
- 25% of a pension fund can generally be withdrawn tax-free.
These policies are all intended to encourage people to save for their retirement. Additionally, pension funds are not generally subject to Inheritance Tax (IHT) on death, which allows their value to be passed down generations without suffering any tax.
The IFS has made five key pensions tax proposals to address the issues identified, whilst aiming to improve equality and the economic efficiency of pension provision:
- Charge National Insurance Contributions (NICs) on pension withdrawals
Payments of income from pension funds are not currently subject to NICs in the same way that salaries or other earnings are. By contrast, when paying into a pension (in the absence of salary sacrifice arrangements) employees can suffer NIC deductions before they can make pension contributions from after-NICs pay.
The IFS proposes that the NIC point should be deferred until the former employee withdraws their pension, with them subject to NICs at that point rather than suffering the NIC charge when adding to their pension fund.
- Charge National Insurance Contributions (NICs) on employer pension contributions
Employers pay NICs on salary paid to employees, whilst contributions made by an employer to an employee’s pension fund do not currently attract this charge.
The IFS suggests this relief should be removed to improve equality between the employed and the self-employed, and to remove the unfair benefit provided to employees whose employers offer salary sacrifice arrangements (which allow remuneration to be paid to a pension fund without deduction of NICs).
This treatment differs to the timing of the employee’s NIC liability proposed in (1) above as the IFS recognises the impracticality of attempting to charge employer NICs when a former employee draws their pension, which may be many years after they left that employment.
- Reform pension withdrawals
The IFS recommends that the pension fund value eligible for the 25% tax free allowance should be capped at £400,000.
Additionally, the IFS report advocates a mechanism which would result in pension withdrawals being supplemented by a 6.25% taxable ‘top up’ amount – the aim being that basic rate taxpayers would be unaffected compared to the current position, higher rate taxpayers would pay more tax on their withdrawal, and non-taxpayers would be better off as they would not suffer tax on the 6.25% top up amount. A worked example is included in section 7.3 of the IFS report.
- Reform the IHT treatment of pensions
Under current rules, ‘pension pots’ are not usually subject to IHT. Furthermore, if a pension-holder dies before age 75, the beneficiaries who inherit their pension fund can generally draw on it tax-free.
The IFS proposes abolishing both treatments, so that pension funds would be subject to IHT in line with most other assets, and inherited pensions would be taxable in the recipient’s hands regardless of when the original pension-holder died. This is intended to align the tax treatment of pension funds with other assets for IHT purposes, whilst primarily affecting wealthier individuals.
- Increase pension allowances
The Annual Allowance caps the amount of pension contributions eligible for tax relief at £40,000 per year (reduced to as little as £4,000 for high earners). Equally, the Lifetime Allowance limits the total value which can be saved in a pension fund tax-efficiently by imposing an additional charge where a pension fund value breaches the maximum (currently a little over £1m).
The IFS suggests increasing both limits, funded by the reforms above, but also that separate caps should apply to Defined Benefit and Defined Contribution pension schemes.
The IFS recognises the significance of the changes proposed in its Blueprint and advocates careful transition. Whether HM Treasury chooses to implement any of the recommendations made by the IFS remains to be seen.
This article reflects the position at the date of publication (14 March 2023). If you are reading this at a later date you are advised to check that that position has not changed in the time since.
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