The IFS proposes better tax treatment on pensions
07 February 2023
The Institute for Fiscal Studies (IFS) has published a blueprint for a better tax treatment of pensions. The report outlines the five main reforms proposed to the government.
The IFS expresses concerns about the competency of retirement incomes for private sector workers and the current system benefiting higher earners. The report suggests that the reforms projected are to create a fairer and more aligned framework and boost savings for those that need it the most (bottom 80% of earners). The proposals have also been a movement for a shift in behaviour and a bridge for more valuable pension pots for the generations to come.
What does the reform package consist of?
1. the 25% tax-free component - the report suggests that the tax-free lump sum should be capped so that it only applies to the first £400,000 of accumulated pensions wealth, at a minimum. This aims to provide a more equal subsidy to all private pensions, benefiting those with a low retirement income
IFS states:
‘‘going further, we propose providing the equivalent of a capped 25% tax-free component for basic-rate taxpayers, but designed in a way that increases the after-tax value of everyone’s pension (up to the cap) by the same proportion – basic-rate, higher-rate and non-taxpayers alike. A 6.25% taxable top-up on all pension withdrawals would achieve this’’
2. the exempt-exempt-exempt (EEE) employee National Insurance Contributions (NICs) relief – the report declares this should be ended and replaced where all individual pension contributions receive up-front relief equivalent to the rate of employee NICs. Gradually, the system should move to one where pension withdrawals are subject to employee NICs
this exempt-exempt tax (EET) approach seeks to align the employee NICs treatment of pension saving with that of income tax. The report explained ‘‘because the employee NICs rate falls from 12% to 2% at the upper earnings limit, this treatment would benefit low and middle earners (who would get up-front relief at 12% and would typically have only part of their pension income above the NICs threshold in retirement) relative to higher earners who make individual contributions (who would get up-front relief at just 2% but would often pay an average rate of NICs far above that in retirement)’’
3. the EEE employer NICs treatment of employer pension contributions – IFS suggests this should be abolished and instead recommends applying employer NICs to all employer pension contributions alongside introducing a new subsidy on all employer pension contributions. It reveals ‘‘whenever the employer NICs rate changes and ensure a uniform incentive for all employers, including those not currently liable for employer NICs (such as small employers) for whom the current NICs exemption is worthless’’
4. tax treatment at death - when an individual dies before age 75, funds that remain in a pension escape income tax entirely. IFS proposes income tax should apply on withdrawals from inherited pensions regardless of the age of death. Secondly, pension pots at death are usually not counted as part of the deceased’s estate for inheritance tax purposes. Therefore, IFS proposes that if there is inheritance tax, it should apply to all forms of wealth and pension pots should be included in estates. The report implies that these measures would raise additional revenue
5. pension limits – the report indicates these should be redesigned with distinct approaches for defined benefit (DB) and defined contribution (DC) arrangements. For DB arrangements, IFS suggest use of regulation to place a cap on the pension benefits. For DC arrangements, IFS propose replacing the current lifetime allowance with a lifetime contribution cap.
IFS says:
‘‘there is an even stronger case for a substantial increase in the annual allowance, and in particular the policy of tapering the annual allowance for very high earners should be ended. This would have the benefit of equalising incentives to save across extremely high and merely very high earners’’.
The model presented in the report indicates ‘‘these reforms would be close to revenue-neutral in the long run, although there is a lot of uncertainty around this estimate…The up-front cost of the package would be £3.3 billion, less any revenue raised from imposing NICs on the pension income of those currently drawing pensions (which would raise around £750 million for every 1 percentage point of NICs charged)…There would need to be a careful transition towards this long-run position. Specifically, where reforms would affect how already-accumulated pension wealth would be treated on withdrawal, there would be a trade-off between implementing a better system more swiftly and taxing some more heavily than they might have anticipated when they made the decision to save in a pension’’.
These recommendations have resulted in mixed opinions among various stakeholders. However, there is mutual call for a longer-term solution, pensions to be more attractive by creating transparency and diminishing complexity. We look forward to the government’s response in return of the proposal from the IFS. You can read more on this topic here.
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