Rachel Reeves is under pressure to launch a £2bn inheritance tax (IHT) raid on pension pots to help fund public spending pledges.
Economists are calling on the Chancellor to introduce a death tax on unspent defined contribution (DC) pension funds, which are currently exempt from IHT.
It came as Jeremy Hunt’s chief of staff revealed that Ms Reeves’ predecessor had considered the policy himself in order to fund cuts to the headline rate of IHT, while Sir Steve Webb, a former pensions minister, said the Treasury was “likely” to revisit the policy.
Senior City sources also fear Labour will push ahead with plans to bring workplace pensions into the scope of inheritance tax. The Institute for Fiscal Studies (IFS) believes it could raise between £1bn to £2bn by the end of the decade.
David Sturrock, an economist at the IFS, said: “The current system gives an incentive to hold onto pension wealth and use other assets to fund retirement.
“This leads to the rather perverse situation where pensions are used as a vehicle for inheritances rather than to fund retirement.
“In terms of the inheritance tax revenues that would be gained from bringing pension pots into inheritance tax, the impacts now would be modest.
“We estimate around £200m extra could be raised now. But the importance of this special treatment is set to grow quickly because more and more people will arrive at retirement with wealth in DC pension pots over time and the sums involved will be larger.
“In the coming decade or so, we estimate that the revenues raised by bringing pension pots into the scope of IHT would be in the range of £1bn to £2bn.”
At the moment, defined contribution pension pots are not subject to IHT. If the pension pot owner dies under the age of 75, the money can generally be withdrawn and used without any tax at all. If the owner dies after turning 75, subsequent withdrawals from the pot by their inheritor are taxed as income.
Introducing IHT would mean taxing pension pots in the same way as other assets when someone dies. The standard inheritance tax rate is 40pc.
Former Labour advisers said that applying IHT to pension pots would amount to a double tax grab that would leave some children facing a 64pc tax charge on their parents’ savings, if they died after turning 75.
Bill Dodwell, the former head of the Office for Tax Simplification, warned that it could lead to big tax charges.
The former Labour adviser on tax administration added that ending an exemption that enables under-75s to pass on their pots completely tax-free made sense.
Mr Dodwell, who until recently was part of an expert panel that looked at how to boost tax compliance, said: “There has never been a good reason why pensions inherited from someone who died before age 75 should not be liable to income tax. After all, the original pension holder received tax relief on pension contributions.”
However, adding an inheritance tax charge as well as income tax would look like a double tax charge on the same item – and could mean paying 64pc for a higher tax rate payer (and more for those in Scotland).
Sir Steve, now a partner at Lane, Clark and Peacock, a management consultancy, highlighted that money put in Isas, another tax-free savings vehicle, was subject to IHT.
He said: “Any review of pension tax relief is likely to look at the favourable tax treatment of pensions when someone dies. The Government may look at ending the way in which wealth held in Isas counts as part of an estate but pensions do not. This might be especially attractive with more people saving into ‘pot of money’ pensions, meaning the tax loss from excluding them from IHT is likely to increase.”
Official figures show around 30pc of men and 18pc of women die under 75.
The IFS estimates £1bn will be bequeathed by under 75s who die without a spouse this year alone.
Adam Smith, the former chief of staff to Mr Hunt, said such a move had been recommended by Treasury officials in the past. Writing in The Telegraph, he said it would be “politically easier” for Labour to remove inheritance tax reliefs.
He said: “Removing the relief available on agricultural land and businesses plus including pensions within someone’s taxable estate would raise £1bn-£2bn a year and was an option we looked at to raise revenue and as a way to fund a cut in the headline rate of IHT. Labour obviously won’t do the latter but may need the former.”
Torsten Bell, an influential new Labour MP and formerly head of the Resolution Foundation think tank, has previously spoken about the need to address “the underlying problems in the pension tax system, which lead to the highest earners getting a very large share of that tax relief”.
The combination of “very generous inheritance treatment” with the lack of National Insurance paid by retirees and the tax-free lump sum all add up to “a tax advantaged scheme” for pension savers.
“Because of that, the benefits are incredibly focused towards higher-income households,” he told MPs last year, before becoming one himself.
Mr Bell has also repeatedly criticised the wider reliefs in the inheritance tax system, including for pension pots, business assets and farmland.
A new report from the think tank Demos said Britain is “unusual” globally in allowing pension wealth to be passed on tax-free and should consider removing or limiting the relief as the savings pots have become a means of passing on wealth, rather than exclusively saving to cover living costs in old age.
Demos said: “Taxing inherited pension wealth makes economic sense – because pensions are currently treated more favourably by the tax system if given as bequests than if used for retirement income, which is what they are meant for.”
Labour has not publicly commented on the possibility of an IHT raid on pensions and has repeatedly insisted it has “no plans” to hike taxes in a number of areas.
That is despite repeated warnings that the party is plotting a wave of tax rises.
Analysts have suggested the party will have to search for creative tax increases after ruling out raising VAT, national insurance or income tax.
The International Monetary Fund has also urged the new Government to raid pension pots.
In its review of the UK economy this month, the global watchdog said Ms Reeves should consider “broadening the base of VAT and inheritance tax”, meaning that the levies should apply to a wider range of goods and assets.
This includes “removing unnecessary reliefs” for inheritance tax, it said, directing the Government to an IFS report which proposed applying the death duty to pension pots.
The Treasury has been contacted for comment.
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