Ministers are urged to limit UK’s generous pension benefits for the highest earners

An influential think-tank believes that pension pots should be subjected to inheritance tax. New limits on tax-free lump-sum withdrawals should also be imposed to “even out” the tax support for retirement savings.

Employers and employees receive tax breaks on their income tax and National Insurance. Incentives to contribute to retirement plans are also provided by inheritance tax. In the UK, around PS115bn is saved in workplace pensions each year.

The Institute for Fiscal Studies believes that more could be done for those who have low incomes in retirement and “who most require it”.

According to the IFS, “The current system for pensions tax gives overly generous tax breaks (those with the largest pensions, those with high retirement incomes, and those who receive large employer pension contributions”)

The IFS published a report on Monday. It outlined a number of policy measures to “even it out” tax support for saving pensions. These include “reducing subsidies where they’re too generous and increasing them wherever saving incentives are weaker”.

One of the most important proposals is to make the 25% pension tax-free lump more generous. Over 55s can take 25% of their pension pot and not pay income tax.

The IFS stated that while this is popular, it provides a substantial tax subsidy for those with high incomes or large pensions. However, it is of no value to those with low incomes in retirement.

It stated that the tax-free component should be limited to 25% of the first PS400,000 of accumulated retirement wealth. This would leave approximately four out of five people approaching retirement unaffected.

Jason Hollands, managing Director at Evelyn Partners, said that a raid on the lump sum, which is tax-free, would be “particularly unwelcome”, particularly for those who might have intended to use it as a way to pay off a mortgage.

“If such a policy were to be implemented quickly, it could leave people very confused.”

IFS believes that reforms are necessary to ensure pensions are not used as an “easy-to use vehicle for avoiding inheritance taxes” and calls for income tax to be charged on inherited pension funds.

Andrew Tully, technical manager at Canada Life, a provider of pensions, stated that including pensions in the IHT environment would make it “hugely unpopular”, as IHT already affects many more people.

It also has the potential to change behaviour, not generating much tax, as wealthy people “rearrange the deck chairs” by taking money out of the pension environment and hiding it from IHT in another way, such as under trust.

IFS suggested that employees be exempted from both income tax and national insurance contributions for their pension contributions. It said that pensioners should pay NICs for their private pension income. This would impact higher-rate taxpayers who have larger employer pension contributions.

“While the theory behind charging NI on pension income may be sound, it’s hard to see a situation in which a government feels it could go down that road without causing fury among older voters,” stated Tom Selby, head, retirement policy at AJ Bell.

These reforms, according to the IFS, will allow the Treasury to be “more flexible” in increasing the lifetime and annual allowance limits. Both of these allowances have been subject to a series cuts over the past decade. It stated that the policy of reducing the annual allowance for the highest earners must end.

Sir Steve Webb, an ex-pensions minister, stated that there was no doubt the current pension tax system is complex, sometimes arbitrary, and has been subject to fragmental reforms for more than a decade.

He warned against any reforms that could lead to retrospective taxation, as savers might suddenly find their careful financial plans no more added up due to a sudden change in rules regarding income tax and NICs.

Webb, a partner with LCP pension consultants, stated that while “fiscal purity” is admirable, a long list complex reforms over a time period of decades is not what pension-savers need right now.

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