Chancellor Rachel Reeves is being urged to consider imposing an inheritance tax rate on pension pots, a move that could generate up to £2 billion annually.
This suggestion comes as she faces mounting pressure to meet public spending targets. The Institute for Fiscal Studies (IFS), a prominent economic think tank, has recommended that unspent cash and defined contribution funds should no longer be exempt from inheritance tax. This recommendation aligns with recent suggestions by the International Monetary Fund (IMF) in its report on the UK.
The IMF, in its separate global economic update, has emphasized the importance of governments adhering to commitments to balance their budgets. However, it also warned that persistent high interest rates could complicate this objective. The Labour party, led by Reeves, has committed to the previous government's targets of reducing debt. However, during the election campaign, economists criticized both major parties for not realistically addressing the difficult choices required, whether in the form of spending cuts or tax increases. With income tax, VAT, and corporation tax hikes ruled out, speculation has grown that Reeves might target other areas such as pensions or capital gains tax.
In a recent Article IV report on the UK, the IMF has recommended that the government consider broadening the VAT and inheritance tax base while reforming capital gains and property taxation. This could include removing unnecessary reliefs for inheritance tax. The IMF's Chief Economist, Pierre-Olivier Gourinchas, mentioned that while it is too early to assess Labour's economic plans comprehensively, some of their proposals align with the IMF's recent recommendations.
David Sturrock, an economist at the IFS, advocated for the proposed inheritance tax rate, highlighting that the current system incentivizes retaining pension wealth and using other assets for retirement funding. This, he argued, leads to a situation where pension pots are used to build up inheritances rather than funding retirement. Although the government would initially gain modest revenues of around £200 million, Sturrock emphasized that the importance of this tax treatment would grow as more people retire with wealth in defined contribution pension pots, potentially raising £1 billion to £2 billion annually in the coming decade.
However, there are concerns that this tax rate could result in double taxation for some. Currently, if the pension pot owner dies before the age of 75, the money can be withdrawn without being subject to inheritance or income tax. If they die after turning 75, withdrawals by heirs are taxed as income. The latter group could face a double tax hit if inheritance tax is also applied.
Adam Smith, former Chief of Staff to the previous Chancellor Jeremy Hunt, mentioned that this reform had been suggested by Treasury officials in the past. Steve Webb, a partner at Consultants LCP, indicated that any review of pension tax relief would likely consider the favorable tax treatment of pensions upon death. The government might also look at ending the exclusion of wealth held in individual savings accounts (ISAs) from estate calculations while pensions are included.
Chancellor Reeves acknowledged the economic challenges highlighted by the IMF, which showed the UK still far from achieving Labour's growth goals. The IMF expects the UK's gross domestic product (GDP) to grow by 0.7% this year and 1.5% in 2025. While this outlook suggests the UK could outpace Germany, France, and Italy, it still lags behind the projected growth in the US and Canada. This underscores the difficulty Labour faces in achieving its pledge of the highest sustained growth in the G7 group of advanced economies.
The IMF also warned that persistent inflation might necessitate maintaining higher interest rates for an extended period, complicating efforts to balance budgets. Despite these challenges, the IMF urged governments to adhere to plans to reduce debt, which could imply higher taxes. Reeves stated, "I am under no illusion about the scale of the challenge facing the economy and the inheritance this new government faces. That is why we are already making tough decisions to fix the foundations of our economy so we can rebuild Britain and make every part of our country better off."
Former Pensions Minister Ros Altmann criticized the inheritance tax proposal as "an absolute travesty," arguing that it would undermine the rationale for holding pensions into older age. A Treasury spokesman reiterated the need to deliver economic stability to support growth, low taxes, inflation, and mortgage rates. Any tax changes decided by the Chancellor will be announced at the next fiscal event, likely to be the budget this autumn.
