Ministers urged to cap Britain’s ‘generous’ pension benefits for the highest earners

Pension pots should be subject to inheritance tax and new restrictions imposed on tax-free lump sum withdrawals to “offset” tax support for retirement savings, according to an influential think tank.

Employees and employers receive tax breaks on income tax, social security and inheritance tax to encourage them to contribute to pension schemes. Around £115 billion a year is saved on company pension schemes in the UK.

But the Institute for Fiscal Studies believes more could be done to support many people facing low-income retirement “who need it most”.

“The current pension tax system provides overly generous tax breaks for those with the highest pensions, those with high retirement incomes and those receiving large employer contributions to pension plans,” the IFS said.

in one report The IFS, released on Monday, laid out a range of policy measures to “offset” tax support for retirement savings, such as:

One of the key proposals is to make the 25 percent tax-free lump sum pension less generous. Those over 55 can draw a quarter of their pension pot without making the money subject to income tax.

“While popular, this offers a large tax break for those with high incomes and high pensions, but is worthless at all for those with the lowest retired incomes: non-taxpayers,” the IFS said.

“At the very least, the tax-free component should be capped to only apply to 25 per cent of the first £400,000 of accumulated pension wealth: this would still leave about four in five people approaching retirement untouched,” it added.

Jason Hollands, chief executive of wealth manager Evelyn Partners, said a heist on the tax-free lump sum was “particularly unwelcome,” especially for those who might have planned to use it to pay down a mortgage.

“If such a policy were implemented relatively quickly, it could put people in a very difficult position,” Hollands said.

The IFS also believes reforms are needed to prevent pensions from being used as a “simple tool to avoid inheritance tax” and wants inherited pension funds to be subject to income tax.

Andrew Tully, technical director at Canada Life, an annuity provider, said the inclusion of annuities in the IHT environment was “hugely unpopular” at a time when IHT is already affecting many more people.

“It also risks changing behavior and not generating much in taxes as wealthier people ‘rearrange the deckchairs’ by taking money out of the retirement environment and protecting it from IHT in other ways, such as through escrow,” he added added.

The IFS proposed that employees be exempted from paying social security contributions on their pension contributions and from income tax relief. In return, however, retirees should pay NICs on their private retirement income — a move that would impact higher-rate taxpayers who enjoy larger employer pension contributions.

“While the theory of levying NI on retirement income may be valid, it is difficult to imagine a situation, at least in the short term, where a government feels it can go down this route without eliciting anger from older voters,” said Tom Selby, head of pensions policy at AJ Bell.

The IFS believes these reforms will allow the Treasury to be more “relaxed” in raising caps for both annual and lifetime allowances, both of which have undergone a number of cuts over the past decade. The policy of reducing the annual allowance for the highest earners should also be ended, it said.

Sir Steve Webb, a former pensions secretary, said there was “no doubt” that the current pension tax system was “complex, sometimes haphazard and has suffered from piecemeal reforms over a decade or more”.

However, he cautioned against reforms that could amount to retrospective taxation, as savers suddenly found that “a last-minute change in the rules regarding income taxes and NICs has thrown their careful financial plans off the rails.”

“While ‘fiscal cleanliness’ is admirable, a long list of complex reforms implemented over a period of decades is not currently what pension savers need,” said Webb, partner at pension advisors LCP.