The Chancellor should reduce the amount that pensioners can withdraw from their pension pots tax-free, the Institute for Fiscal Studies (IFS) said, but avoid setting a flat rate of relief on pension contributions.
Rachel Reeves is rumoured to be considering a shake-up of pension tax reliefs in the October Budget as she seeks to address a challenging fiscal inheritance.
The IFS said there was a “strong case for reform”, particularly as the system offers generous tax breaks to those with the biggest pensions. However, it cautioned that “change needs to be carefully thought through”.
Currently, savers can withdraw 25 per cent of their pension tax-free up to a limit of £268,275, but the IFS said Rachel Reeves should reduce the limit to £100,000.
The think tank it was “hard to justify” offering subsidies to savers who were already relatively wealthy. “The incentive should be removed from those with larger pensions,” it said.
Such a move would impact around one in five retirees, mainly among the wealthy, and raise around £2bn per year, the IFS said.
In addition, the IFS argued that pension pots should be subject to inheritance tax, which could raise several hundreds of millions.
“Reducing the cap on the amount that can be taken tax-free from a pension and bringing pension pots into the scope of inheritance tax would reduce the tax advantages enjoyed by those drawing large pension incomes and those inheriting pension pots,” David Sturrock, senior research economist at the IFS said.
However, the IFS urged the Chancellor to stay clear of setting a flat rate of tax relief for pension contributions, a move which the Fabian Society, among others, have advocated.
Under the current rules, contributions attract income tax relief in line with the person’s marginal tax rate, while pension income is taxed.
But the IFS said moving to a flat rate of tax relief would be “damaging, complex and inequitable”.
In particular, the IFS said it would be unfair on higher-rate taxpayers in work and retirement because they would be forced to pay tax twice on the same income.
“There is no coherent logic to making relief on contributions flat-rate while continuing to tax pension income at the individual’s marginal rate,” it said.
The Treasury has repeatedly said that “difficult decisions lie ahead” and that decisions on tax and spend “will be taken at the Budget in the round”.