The Institute for Fiscal Studies today (6 February 2023) released a controversial report, ‘A blueprint for a better tax treatment of pensions', covering a number of proposals for the reform of pensions taxation, including scrapping the 25% tax-free lump sum and bringing pension pots under the scope of inheritance tax.

Jon Greer, head of retirement policy at Quilter, said: "On the surface of it, the proposals in the IFS report on pension taxation, out this morning, will almost certainly elicit some consternation from the industry and public. But regardless of whether people agree or disagree with the proposals they certainly take pension taxation in a different direction and this should be welcomed.

"One good thing set out in the report is the idea of consigning flat rate relief to the ‘ideas bin'. There are mighty fine reasons for that, as flat rate relief is a big headache for net pay arrangements to implement as well as for HMRC and there are issues with salary sacrifice being used as an easy mechanism to avoid its effect. There is also the not so small issue of defined benefit pension schemes where the deficit contribution treatment under flat rate relief just felt too hard a nut to crack. This is all before you deal with the thorny issue of ongoing defined benefit accrual. 

"The paper also discusses restricting tax-free cash (TFC). The current system of EET (exempt exempt taxed) is merely tax deferral with the exception of tax-free cash. This is arguably ‘the' tax break on pensions. Restricting TFC is perhaps a simpler proposal as you don't get into tricky areas of double taxation. However, the thought of restricting TFC will not be looked upon with the cold light of logic. It is emotive and always has been. Not a budget nears without at least rumours of TFC restrictions surfacing and that's been the case every year since I joined the industry in 1998. 

Greer continued: "But looking at the reality of it, you'd only save significant tax revenue if the change was applied to existing pension savings and that runs against the usual transitional protection that the Treasury usually apply. If government applied it retrospectively there would be such a backlash that the Conservatives would unlikely be re-elected for some time. You could even go as far to suggest that the government might be subject to claims of human rights infringements. People would likely feel that an unwritten pact had been broken and it could seriously damage the reputation of pensions. 

"If you did tax some element of the lump sum going forward it is presumably the case that this could, for some people, put a basic rate taxpayer in retirement into higher rate tax. PAYE tax on flexible withdrawals especially lump sums is already a difficult area for customers to comprehend. 

"Some of the proposals may have significant challenges in their actual administration. For example, there is a proposal to make all pension withdrawals subject to tax and then get a refund from HMRC to get your ‘tax relief' on the lump sum. Whilst this is an option it would add to the already significant  pension reclaim tax figures that leave people regularly out of pocket when lump sums get taxed at the emergency rate. Last year alone, £134m was repaid to savers in 2022 in overcharged tax. This works out at an average of £3,215 per claim made. Implementing this proposal might increase HMRCs administration significantly and presumably require it to police the maximum TFC regime to some degree."

Greer further said: "The proposal to subject pension income to NICs has some interesting aspects, the transition to it could take some time otherwise you'll have a degree of double NICs.

"Ultimately changing the current regime isn't easy because there is no silver bullet to fix all the problems but radical ideas are never easy to stomach and while many of the proposals may have some tricky practical application and perhaps some unintended consequences we need to have these conversations as they move the debate forward on an issue that will have a profound impact on the fortunes of the generations to come."

Tom Selby, head of retirement policy at AJ Bell also commented on the IFS report: "The pension tax reforms set out by the IFS are balanced and well thought through. While often think-tanks will jump to radical proposals such as scrapping higher-rate pension tax relief in favour of a flat rate, the IFS rightly acknowledges this would create significant challenges, particularly for defined benefit (DB) schemes.  

"Some of the ideas put forward here, in particular capping pensions tax-free cash, would be deeply controversial and risk a backlash of biblical proportions from voters. Others, such as making the tax treatment of pensions on death less generous, are potentially more doable but still come with challenges.

"The key, as the IFS acknowledges, is building a framework that is simple, provides savers with stability and maintains sufficient incentives necessary to ensure people save enough for later life. 

"This need for stability is one of the reasons the idea of establishing a new pension tax commission, with a focus on simplification and encouraging more people to save for retirement, has appeal. Such a commission could potentially build the political consensus necessary to push through sensible, long-term reforms that can stand the test of time."

"The ability to access 25% of your pension tax-free is one of the few parts of the retirement system that the majority of people both understand and value. As such, any move to remove or cap the available tax-free cash would risk undermining the fragile savings culture being built under automatic enrolment. It would also be deeply unpopular - a key factor given a general election is drawing near. 

Selby continued: "It is far from clear how the transition from the current system to a reformed one would work in practice. Those who have bult up pensions under the existing system would, presumably, have any tax-free entitlement honoured if the UK were to shift to an alternative framework. 

"This would inevitably mean creating a complex set of rules whereby those who have pensions already have that tax-free cash entitlement ringfenced, with new contributions moving to a different set of rules.

"It would therefore risk not only discouraging retirement saving but layering on additional complexity that would remain in the system for decades."

Turning to the scrapping of tax-free death benefits of drawdown for deaths before age 75 and bring pensions into the scope of IHT, Selby added: "The tax treatment of pensions on death is generous and, given how tight finances are at the Treasury, it would be no surprise if this came under the microscope.

"Under former Chancellor George Osborne the Government scrapped the controversial 55% ‘death tax' on pensions. These new proposals from the IFS are not quite as pernicious, but come close to introducing a comparable penalty on death.

"Almost a decade on from Osborne's reforms, the Government might be tempted to turn back time to help rake in a little more cash for the Treasury coffers. 

"If there were to be reform in this area, one of the big questions would be whether those who have contributed to a pension or made spending decisions in retirement based on the current system would be protected. Without protection, the immediate moving of the tax goalposts would risk turning a sensible financial decision into one that costs people tens of thousands of pounds in tax. Those facing a colossal tax bill as a result of what would feel like a retrospective tax change would understandably feel extremely hard done by.

Selby further said: "However, creating a new protection regime - as we have seen when the lifetime allowance has been cut previously - would layer additional complexity onto an already difficult to navigate system and limit the amount of cash such a move would raise.

"Any move to levy a new pensions death tax would also be politically risky, and politicians would inevitably face a significant backlash from savers and retirees ahead of the general election.

"In terms of the financial decisions people make, the most obvious consequence of increasing taxation on death would encourage more people to spend their pension pots during their lifetime. As things stand, it can often be sensible to spend your non-pensions assets first in order to minimise the IHT your beneficiaries will pay on death."

On scrapping employer National Insurance relief on contributions, Selby continued:  "If the Treasury is lining up pensions for a tax raid at the upcoming Budget, there is an argument levying National Insurance on employer contributions is one of the less painful ways to raise some much-needed cash. 

"It would certainly be preferable to anything which undermines the retirement saving incentives of individuals, such as capping tax-free cash or ditching higher-rate relief.

"The big stumbling block here would be the extra cost it would load on businesses at a time when the UK is teetering on the brink of recession. Given the Government's desperate desire to spur growth in any way possible, it seems unlikely an effective hike in businesses' NI will gain much traction." 

Selby further argued: "It is something of an anomaly of the UK tax system that pensioners do not pay National Insurance contributions. After all, older people are more likely to rely on public services like the NHS - so, theoretically at least, it would make sense for them to help fund those services by paying NI in the same way working people do.

"While the theory of charging NI on pension income might be sound, it is hard to imagine a situation, in the short-term at least, where a Government feels it can go down this road without sparking fury among older voters. 
"Given the proximity to a general election, hiking NI for pensioners is probably towards the bottom of both Rishi Sunak and Keir Starmer's current to-do lists."

As for splitting DB and DC lifetime limits, he said: "The crisis engulfing the NHS has exposed the fact that the unintended consequences that can arise from a poorly designed system of tax allowances. Defined benefit and defined contribution pensions are fundamentally different, and so the idea of having a different framework for controlling each is sensible and merits more detailed exploration.

"Since ‘Pension Simplification' in 2006, the UK pension tax system has become a mess of complexity. Any changes to lifetime limits would need to be focused on simplifying the rules and ensuring people have sufficient incentives to save for retirement.

"Similarly, the plethora of annual allowances that exist for different people depending on their circumstances is an absolute nightmare and undermines efforts to engage savers. If we can shift towards a world where there are a small number of easy-to-understand, sensible allowances, that would be a huge benefit to millions of savers and retirees."

Jason Hollands, managing Director at wealth manager Evelyn Partners, also weighed in with early comments, highlighting how the proposals could undermine faith in private pension saving at a time when the retirements of most of today's workers need to be better-funded: "People need to be encouraged to make appropriate provision if they want to avoid facing a steep decline in the living standards they have been used to when retiring. 

"Our current system is certainly far from perfect, but regular tinkering has a corrosive effect on the savings impetus, giving the impression that the system is in flux. This risks undermining confidence in private pension saving as people fear that the goal posts will just keep getting moved." 

Hollands said that if you were designing a pensions taxation system from scratch, it might not look like it does now, but that doesn't mean it can be easily improved or ‘made fairer' by piecemeal reforms. 

"The taxation of pensions is just one component of the overall tax system, and so while higher earners undoubtedly gain a significant share of overall pension tax reliefs under the current system, it is also the case that they pay a huge slice of personal tax receipts, including 73% of all income tax. The tax system's definition of ‘high earner' is also getting alarmingly broad given frozen thresholds, with an estimated record 5.5 million paying 40% this tax year, a 15% increase in numbers over the prior year.  

"A raid on the tax-free lump sum by capping it would be particularly unwelcome, especially by those who may have planned to use this for purposes like paying off a mortgage. Were such a policy to be implemented relatively quickly, it could leave retirement plans in a very difficult place.  

Hollands continued: "A scrapping of the tapered annual allowance would be welcomed, however, as would a replacement of the lifetime allowance and the potential lifting of the annual allowances whose real values have been dramatically eroded by both nominal cuts and the effect of inflation. These measures as the IFS argues would, among other things, go some way to encouraging some older workers back into the workforce - something the UK needs right now. 

He added that levying inheritance tax on pension savings as well as income tax would turn people off pension reforms: "IHT is already a very unpopular tax across almost all income and wealth cohorts. While the IFS might be seeking a sort of ‘uniformity' by imposing IHT on all assets, it's not entirely clear that this is a sensible step from where we are at the moment.  

"It would for instance 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. Of course, the burden would not fall on the savers, but typically on their children and grandchildren who may not themselves be affluent at all.  

"The effect could be to swing incentives towards spending pension pots early in retirement with unforeseeable consequences. It could also nudge people towards other tax-efficient ways to pass on wealth, like fuelling further investment into assets that attract Business Relief, such as AIM shares or Enterprise Investment Schemes, which are not suitable for everyone. 

"Another measure unlikely to be well received would be the application of National Insurance Contributions on pension withdrawals, a de facto tax rise on retirees. In theory, National Insurance is a levy to qualify for the state pension and other benefits, so having to continue to pay in at the time of actually receiving the benefit may seem illogical."