The UK’s Institute for Fiscal Studies (IFS) propose to scrap the 25% tax-free lump sum and other reforms to the UK’s pension taxation system, including and bringing pension pots under the scope of inheritance tax.
This would mean that bequeathed pensions pots could first be taxed at 40% on inheritance and then the remainder taxed at anywhere up to 45% via income tax, according to its recent report, “A blueprint for a better tax treatment of pensions.”
Currently, people are allowed to receive up to 25% of their pension savings as a tax-free lump sum when they access their pension. Under the proposed reforms, this would no longer be possible.
Inheritance Tax (IHT) is already a very unpopular tax across almost all income and wealth cohorts, so it’s unclear whether this reform would be beneficial.
If someone inherits a defined contribution pot, they can nominate someone else to get any money they do not use before their death.
If the pension scheme’s rules allow it, this money will be taxed at up to 55% as an unauthorised payment.
In most cases, any pensions inherited can be passed outside of an estate and so won’t be subject to Inheritance Tax if the pension scheme administrators have discretion over whom to pay death benefits to.
Early Retirement is Killing Britain’s Productivity
Some experts say the new provisions could motivate or encourage older workers back into the workforce – something the UK needs right now.
The UK is currently facing a labour shortage due to an increase in economic inactivity post-pandemic, according to the House of Lords Economic Affairs Committee.
This is largely attributed to early retirement, which has been identified as the single biggest cause of current shortages in the labour market.
In its recent report titled, “Where have all the workers gone?” the Committee found that an extra 565,000 people have become economically inactive since the start of the pandemic.
The main reasons for this shift are retirement, increased sickness, changes to migration, and the UK’s ageing population.
Data from the Office for National Statistics (ONS) revealed that nearly one-third of UK businesses are experiencing labour shortages, with experts speculating that wealthy professionals leaving their jobs is driving this crisis.
The official retirement age in the UK is 66, but more people in their 50s and early 60s have been retiring ever since Covid hit.
A recent ONS report revealed that less than one in ten of these adults had done so due to health concerns — workers are leaving the job market out of choice.
The Resolution Foundation found that a jump in people taking early retirement disproportionately comes from highly paid workers over age 50, making it more difficult to persuade them to return to work.
Wider Support is Still Needed
Regardless of the labour shortage, financial experts say the new proposals to overhaul the Pension System are likely to elicit concern from both industry and the public, as levying inheritance tax on pension savings as well as income tax could turn people against any reform to pension schemes.
The IFS report released on 6 February 2023 also suggests ending the Exempt-Exempt-Exempt (EEE) employee National Insurance Contributions (NICs) treatment of employer pension contributions and capping pensions’ tax-free cash, which could lead to a backlash from voters.
Not surprisingly, the reaction to the new UK plan to reform pensions taxation has been largely negative. Especially the proposal to remove the 25% tax-free lump sum.
Jon Greer, head of retirement policy at Quilter, said that levying inheritance tax on pension savings as well as income tax would turn people off pension reforms altogether.
The Financial Times warned that cutting or scrapping the tax-free cash limit on pension savings could have a significant impact on savers.
Corporate Adviser’s editor-in-chief David Selby noted that it is far from clear how the transition from the current system to a reformed one would work in practice.
Overall, there are also concerns that these proposals will be deeply unpopular with voters and could lead to a public backlash so the UK government will probably need to carefully consider its next steps before making any major changes to pensions taxation.
The views expressed in this article are not to be construed as personal advice. You should contact a qualified and ideally regulated adviser in order to obtain up to date personal advice with regard to your own personal circumstances. If you do not then you are acting under your own authority and deemed “execution only”. The author does not accept any liability for people acting without personalised advice, who base a decision on views expressed in this generic article. Where this article is dated then it is based on legislation as of the date. Legislation changes but articles are rarely updated, although sometimes a new article is written; so, please check for later articles or changes in legislation on official government websites, as this article should not be relied on in isolation.
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