The government has been urged to take swift action to address the "overly generous" tax treatment of pension pots at death, in an effort to make the system fairer and remove the “perverse incentive” to avoid using a pension to fund retirement.

The report from the Institute of Fiscal Studies (IFS) and Abrdn Financial Fairness Trust, Death and Taxes and Pensions, revealed that pensions are currently treated more generously as a vehicle for bequests than they are as a retirement income vehicle.

Indeed, the research suggested that keeping savings in a pension can be a highly effective way of avoiding inheritance tax, explaining that any funds that remain in a pension at death, at any age, are not subject to inheritance tax.

According to the report, this means that there is a substantial incentive, for those who can, to use non-pension assets to fund their retirement while preserving their pensions for bequests.

Highlighting an "extreme example", the research showed that a married couple could each leave £1,073,100 in their pensions free of inheritance tax, representing a combined £2,146,200, whereas if they both bequeathed the same amount in other financial assets instead there could be a total inheritance tax bill approaching £600,000, or more.

The report also highlighted further issues around income tax, explaining that although money received from a pension is typically taxed, with pension contributions are already free from income tax, when someone dies before age 75, funds remaining in their pension escape income tax entirely.

For a basic-rate taxpayer, for instance, the difference in income tax between inheriting a £100,000 pension pot from someone who died the day before they turned 75 and someone who died the day after turning age 75 would be £20,000, while a higher-rate taxpayer receiving a £1,000,000 pension pot could see the difference in income tax rise to £400,000.

In light of these concerns, the report outlines two core solutions designed to make the tax treatment of pensions at death fairer and more economically efficient.

In relation to inheritance tax issues, the research suggested that pension pots should be included in the value of estates at death for the purposes of inheritance tax, arguing that if there is going to be an inheritance tax, it should apply evenly across all forms of wealth.

It also suggested that basic-rate income tax could simply be levied on all funds that remain in pensions at death, or alternatively, that current income tax rules could extend to those inheriting pension pots from someone who dies before age 75.

This would mean levying income tax when the person inheriting the pension pot withdraws the funds from it regardless of the age of death of the deceased.

The report stated that the revenue raised by these reforms, while perhaps relatively modest in the short term, could be substantial in the longer term, estimating that these changes could raise the equivalent of around £1bn a year in extra inheritance tax revenue, if those benefiting from pensions freedoms were to leave half their pension pots intact at death.

It suggested that this revenue could also be used to cut inheritance tax in ways that made the overall system both fairer and more efficient, estimating that this would be enough to reduce the rate of inheritance tax from 40 per cent to 35 per cent.

However, the report argued that there is now a premium on announcing any reform quickly, stating that “swift action” is needed to ensure people no longer making financial decisions under what should be false expectations of future tax breaks.

It also warned that, as with any increase in wealth taxes, some degree of retrospective taxation would be inevitable, clarifying however, that this is "precisely why change needs to be announced and implemented as soon as possible".

Indeed, IFS research economist and author of the report, Isaac Delestre, argued that " the situation where the tax system treats pensions more generously as a vehicle for bequests than it does as a retirement income vehicle needs to be swiftly ended".

She continued: “Whether by accident, design or inertia, the tax treatment of pension pots at death has become increasingly eccentric.

“With the amount of wealth held in defined contribution pensions increasing year-on-year the unfairness and inefficiency this bizarre tax treatment creates will only get worse.

“Pension pots should be included in the value of estates for the purposes of inheritance tax and income tax should be charged on inherited pensions, regardless of how old a person is when they die. The coalition government missed the opportunity to fix the tax treatment of pensions at death when pension freedoms were introduced.

“It is not yet too late to act, but the longer the government delays, the more painful such reforms will become. Failure to embrace relatively small reforms now will leave a legacy for which the Chancellor’s successors will not thank him.”

Abrdn Financial Fairness Trust chief executive, Mubin Haq, added: “Those with wealth are increasingly being urged to use their pension pots as a way to pass on inheritance. This legal route bypasses inheritance tax and in some cases income tax.

“Whilst this avoidance measure is open to all, it is the wealthiest in society who are set to benefit the most, escaping tax bills which for a couple could otherwise be around £600,000 or higher. Pension pots are there to fund retirement, and government must act to close this loophole.”

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