Navigating The Stealth Tax Maze

The government's recent move to scrap the Lifetime Allowance (LTA) has been met with mixed reactions - celebrated by some as a significant stride towards simplification, while criticised by others as yet another tax advantage for the affluent.

I have previously given my opinion on the removal of LTA in this article.

Jeremy Hunt's proposal was straightforward: by eliminating the risk of doctors exceeding the Lifetime Allowance, he aimed to incentivise their return to service. Additionally, he sought to simplify pensions, thereby motivating more individuals to save for their later years.

*ironically I'm writing this over the days Junior Doctors are on strike and its being reported the Government are drawing up plans to force them back to work.

As the dust settles and the intricacies of the draft legislation come into focus, it becomes glaringly obvious that the path to simplification is far from straightforward.

In a move that seems to invert the message of Robert Frost's famous poem, "The Road Not Taken," this policy proposal appears to be choosing the road of complexity over simplicity.

Unlike the poem, where the road less travelled made all the difference, here the government's choice of a more convoluted path seems to achieve much less. After all, why opt for the simple route when a labyrinthine one that accomplishes far less can be chosen instead?

I understand the introduction of the two new lifetime limits, the Lump Sum Allowance (LSA) and Lump Sum and Death Benefit Allowance (LS&DBA), even if I don't necessarily agree with them.

In this article, though, my focus is on examining the reasoning behind the proposed new 'death tax' for individuals who die before reaching 75.

The logic behind implementing a tax that can be easily circumvented is puzzling, to say the least - unless there's more to it than meets the eye.

The Proposed New Death Benefits

Currently, if you pass away before the age of 75 without accessing your Defined Contribution pension, your beneficiaries can inherit it tax-free, provided it's within the old Lifetime Allowance (new LS&DBA).

After 75, the tax landscape shifts; inherited pension benefits are taxed at the beneficiaries' marginal rate, whether received as a lump sum or income.

The new proposals aim to tax income from inherited pensions if the original holder dies before 75, although this tax can be sidestepped if the funds are taken as a lump sum.

Firstly, introducing a new tax while maintaining this age 75 distinction is illogical. The age 75 cut-off is an outdated remnant from the era when annuities had to be purchased by that age and it's high time for it to go.

Standardising the rules for both pre and post 75 would be both fairer and easier to implement.

I've always found it puzzling that pension benefits become tax-free upon the holder's death, despite being taxable as income when the holder is alive.

Therefore if they are to introduce new rules, the government should take sensible action and tax all pension death benefits as income for the beneficiary.

Most people with pensions aren't preoccupied with the tax benefits of dying before 75; they're more concerned with living beyond that age. A uniform tax rule would likely face minimal opposition, as the focus for most is on longevity and consistent taxation of their pensions.

So, the question remains: why keep a tax-free option at all?

The Real Underlying Motive

The convolution of the new rules appears to be lifted straight from a page of the nudge economics playbook, designed precisely to encourage people to withdraw money from pension accounts.

At first glance, the choice seems simple: take the money tax-free now or leave it to be taxed as income later. Most would instinctively opt for the first choice.

Why would the government offer such an option? It's certainly not out of altruism, especially at a time when they need to and are seeking to boost tax revenues.

The reality is that the second option - paying tax over an extended period - would likely be more beneficial for most individuals and families generationally.

If my proposal to tax all benefits as income were adopted, beneficiaries would likely opt to keep the capital within the pension to benefit from tax-free growth, only paying income tax when they eventually draw from it.

The current proposals subtly encourage beneficiaries to take the entire amount as a lump sum. While this may be tax-free upon receipt, it shifts the funds into a taxable environment, subjecting them to capital gains, income, and crucially, inheritance tax.

Over the long term, this approach would result in a much higher tax burden compared to leaving the money in the pension.

A Case Study: The £1 Million Pension Pot

Let's consider an inherited pension pot of £1 million.

If taken as a lump sum, it's tax-free initially but then becomes part of the estate, making it liable for a 40% Inheritance Tax (IHT) plus subject to taxes on all future gains and income.

Now, compare this scenario to keeping that £1 million invested within a pension and drawing it as income. Accounting for taxes, a pension fund will typically grow at least 1% more annually than an investment held outside of a pension.

Over a 20-year time horizon, drawing an indexed income of £25,000 from a pension would result in a remaining fund of £1.55 million. In contrast, an investment portfolio outside a pension, with the same net income, would be valued at £1.45 million - a relatively minor difference on the surface.

However, the pension fund offers the flexibility to benefit multiple generations, including grandchildren, without the need for gifting, plus allowing parents to maintain control over the funds.

Additionally, the £1.55 million remains outside the beneficiaries' estate, translating to a potential IHT saving of £580,000.

Conclusion

The proposed changes to pension death benefits seem to be at odds with the government's initial objective of streamlining and simplifying the pension system. While those who are well-informed or have access to expert advice can successfully navigate these new complexities, there's a real risk that the less informed or those without such access may make decisions that are not in their best financial interest. These choices could result in higher tax liabilities and less efficient methods of transferring wealth to future generations.

What amplifies this concern is the shifting landscape of how financial advice is consumed. As younger generations increasingly turn away from traditional financial advisers in favour of quick tips from apps and social media platforms like TikTok, the likelihood of making uninformed decisions grows. These platforms, while convenient, often lack the depth and nuance that complex financial planning requires.

This trend could have long-term implications, potentially leading to a whole generation making suboptimal financial choices that could affect their financial stability and that of their heirs. It's not just about the immediate impact; these decisions have a ripple effect that could span decades, affecting not just individual families but potentially having broader economic consequences.

Therefore, it's more crucial than ever for pension holders to be fully aware of the details of these proposed changes. Education and awareness-raising are key, and this is an area where financial advisers, educational institutions, and even policymakers can play a significant role.

Failing to address this issue now could result in a future where the gap between the financially savvy and the financially vulnerable becomes increasingly wide, undermining the very goals that pension simplification aimed to achieve in the first place.