Stop inheritance tax perk on pensions, says IFS

The government should end “unfair” inheritance tax loopholes on pensions and AIM shares, according to the thinktank the Institute for Fiscal Studies (IFS).

Pension pots sit outside the inheritance tax net. Making them liable for the tax could pull in an extra £200 million in revenue, rising to around £400 million in 2029–30, says the IFS.

Currently, any defined contribution pensions can be passed on tax-free if the saver dies before they reach 75. After that age, withdrawals from the pension pot are subject to income tax at the beneficiary’s highest rate.

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The thinktank argues that inheritance tax (IHT) reliefs and exemptions on pensions, AIM shares, farms and businesses are “unfair, have substantial revenue costs, and inappropriately distort economic choices”. Abolishing a trio of loopholes could raise £2.7 billion for the Treasury in the current tax year.

However, staging an inheritance tax raid on retirement savings before a General Election would be a risky move by the government, given how politically sensitive pensions can be. It could also upset the “grey vote”. 

It remains to be seen what a Labour government would do to pensions, although any so-called tax loopholes are likely to come under the microscope if it won the next election.

Jason Hollands, managing director at the wealth manager Evelyn Partners, says bringing defined contribution (DC) pensions into estates for IHT purposes would be a “very negative move”.

He adds: “IHT is widely believed to be one of the most hated forms of tax – in the eyes of many, akin to graveyard robbery – so extending its reach further would be a very aggressive move.”

IHT receipts hit a record high of £7.5 billion between April 2023 and March 2024, £400 million more compared to a year ago.

Nonetheless, the IFS argues that the government should take action to improve the tax system. It says: “The total number of IHT exemptions is difficult to even count, with the Office of Tax Simplification reporting 88 reliefs a decade ago. The government could make inroads to improving the system in three ways.”

“Stop pensions being used as inheritance tax avoidance vehicles”

The IFS asserts that pensions are becoming inheritance tax avoidance vehicles.

It says: “Those with sufficient other wealth to fund their retirement and who want to pass on some wealth when they die are strongly encouraged (by the tax system and as a result their financial advisers) to use their pension as an inheritance tax avoidance vehicle.

“This exemption serves no economic purpose and is clearly unfair. Pension pots should be brought into the scope of inheritance tax, with an allowance for the fact that income tax may be paid on the income withdrawn from them.”

The thinktank adds that as DC pension pots become more prevalent, thanks to auto-enrolment, the revenue gain from bringing them into the scope of IHT will increase, reaching up to £1-2 billion (in today’s terms) in the coming decades.

According to Hollands, if a government did ever abolish the IHT relief on pensions it would have a “major impact on the beneficiaries of those with residual assets in their private pensions on death, typically children or grandchildren, and would likely encourage people to draw down more heavily on their pensions, or increase lifetime gifting instead”.

“Remove special treatment of AIM shares”

Since 1996, shares listed on the AIM (formerly called the Alternative Investment Market) that have been held for at least two years before death get a 100% relief from IHT as part of business relief. 

The IFS says this “distorts investment choices towards these types of shares, particularly for older people seeking to minimise their inheritance tax liability. There is no rationale for this relief based on supporting family businesses as AIM shares are held at arm’s length in a similar way to regular shares”.

It estimates that the removal of business relief for AIM shares could raise around £1.1 billion in the current tax year, rising to £1.6 billion in 2029–30. 

Hollands warns that such a move would have “major ramifications for AIM, which is already shrinking, at a time when it is widely acknowledged that the UK equity markets need a new lease of life as increasing numbers of UK companies are being lured to overseas exchanges like NASDAQ”. 

He adds: “Estimates vary, but AIM portfolios designed to mitigate IHT represent a significant pool of capital for the AIM market.” 

Withdrawing that relief could be very disruptive to AIM, “especially if business relief was yanked away without a transitional period of grace and it might accelerate the trend of moving listings overseas”, says Hollands.

“Cap agricultural and business reliefs”

Agricultural and business reliefs (with the latter including the relief for AIM shares) currently cost around £400 million and £1.4 billion a year, respectively, according to the IFS.

It says that while there is a “strong economic case for completely abolishing” the reliefs, there is “likely to be strong pressure on politicians not to make a change that would raise taxes for those passing on family farms and businesses”.

Therefore, it suggests capping the amount of business and agricultural relief at £500,000 per person, with the unused portion of the allowance being transferable to a surviving spouse or civil partner. This would mean a couple could pass on a farm or business worth £1 million. 

The thinktank estimates that a £500,000 cap would raise £1.4 billion in the current tax year, rising to £1.8 billion in 2029–30.