Tax changes affecting pensions on divorce

At such a stressful time of year, it is perhaps unsurprising that family strain starts to rear itself but the reality of going through a divorce is that it is tougher, harder and more emotionally, physically, mentally and spiritually challenging than films make it out to be. 

Financially, too, divorce has serious implications for family wealth, for asset sharing, children's savings and for pension planning.

Recent tax changes in the UK have also created more challenges for financial planning in terms of pension sharing on divorce.

The ways a pension can be split following a divorce is covered in the first article in this guide.

Richard Morley, partner for DBO's tax dispute resolution division, comments: "As the clock struck midnight on New Year's Eve, many people will be assessing how life is going, including reflecting on their relationships.

"January is notorious, more so than any other month, as the time when many couples file for divorce."

The recently announced reduction of the money purchase annual allowance makes it very difficult for the debit spouse to rebuild their pension following a sharing order on divorce in favour of their spouse.David Trenner 

He says while the repercussions on family and money are likely to be high on both parties' agendas, tax is an "important consideration".

Mr Morley comments: "There are numerous tax issues that may affect each parties' wealth before and after separation and divorce."

According to Martin Tilley, director of technical services for Dentons Pension Management, the "problem" with the new pension flexibility is although it allows more options and greater access to the funds to enable an easier division of assets on divorce, tax treatment on pensions could be problematic.

Mr Tilley explains: "A post-age 55 divorcee can have much greater access to their funds now, which may allow cash release, which can permit liquid asset division which might otherwise have not been possible.

"Similarly, a sharing order to a spouse might permit them to access funds in a more flexible and speedier way than was previously possible under, for example, capped drawdown.

"However, with all these pension flexibilities comes the consequence of taxation."

For example, while more people can access drawdown, the tax burden on the money drawn down could be increased.

Figure 1: Tax Tips

DBO's Mr Morley has provided five top tax tips for advisers to consider when it comes to asset sharing:

• Calculate the value of net assets held by each party. Resultant net assets are then divided between the parties. Assets such as property or shares in family companies may need specialist valuations.
• Both spouses should consider whether they need to file UK or overseas tax returns, depending on the income and gains they have after their divorce.
• Look at the assets both want to have after the divorce, including cash, shares or property. If cash is desired but other assets are given, then advice is needed to quantify capital gains tax payable after the assets are sold to generate the cash, as the client will only be left with the net amount. It may be easier or better to negotiate to receive cash or assets of a higher value to mitigate tax payable on sale.
• If maintenance is payable to a spouse or for children after a divorce, tax consequences should be checked, especially if the order was made by a foreign court.
• Pensions and life assurance policies are complicated, especially in a period of ever-changing pensions rules. Tax and investment advice should be sought if these are affected by a divorce.

Money purchase annual allowance

​There is also the potential that divorcees wanting to add to their pension post-sharing could risk breaching the money purchase annual allowance cap.

The MPAA was a method of drawing pensions introduced in April 2015 to improve flexibility for retirees as part of the pension freedoms regime.

However, it may have been used as double-tax break, which chancellor Philip Hammond intends to end by slashing the £10,000 annual limit by £6,000, as made clear in his December 2016 Autumn Statement.

In a 19-page consultation published by HM Treasury alongside the Autumn Statement, the government said the MPAA had created a loophole enabling people to take money out of their pension, while still investing into it tax-free. 

According to the consultation paper: "Since April 2015, on reaching normal minimum pension age, currently 55, a person can access their pension flexibly and continue to save into a pension.

"However, the risk of acting against the spirit of the system remains and the MPAA was introduced and set at £10,000.

"While the MPAA reduces this risk, it does not eliminate it. An individual still in work can invest up to £10,000 of their earnings, tax-free, into a pension while also drawing out their existing defined contribution (DC) pension savings.

"Although against the spirit of the tax system, acting in this way reduces an individual’s tax bill by 25 per cent and, at the level of £10,000, this means £1,125 for an additional rate taxpayer."

As a result, Mr Hammond announced: "For pensions that have been drawn down, I will reduce to £4,000 the MPPA, to prevent inappropriate double tax relief."

Those most likely to be affected are those who are accessing their pension using an uncrystallised fund pension lump sum (UFPLS).

Denton's Mr Tilley explains this change could affect the tax status of pension sharing on divorce.

He says: "A divorcing spouse taking advantage of flexi-access drawings or UFPLS to generate cash to use in division of liquid assets might be reducing their ability to top up their pension through future contributions, as they would be subject to the reduced MPAA."

In August 2016, Association of British Insurers (ABI) data suggested 300,000 cash withdrawals have been made using UFPLS in the first 12 months of availability.

David Trenner, technical director for Intelligent Pensions, agrees: "The recently announced reduction of the MPAA makes it very difficult for the debit spouse to rebuild their pension following a sharing order on divorce in favour of their spouse."

Lifetime allowance

Meanwhile, according to Mr Trenner, the reduction in the lifetime allowance could have "very different impacts" for the debit and the credit spouse on pension sharing.

While one spouse (the debit) spouse will have to be limited to the new £1m cap, the credit spouse could end up with exceptions to this limit.

Most people will find this very challenging to navigate without an adviser.Jessica List

A Personal Finance Society's 2016 Technical Connection article explains: "The pension credit member will be entitled to claim a pension credit enhancement factor to his or her lifetime allowance.

"As usual this will be expressed as a factor (a credit of £250,000 on a lifetime allowance of £1m will be 0.25). If the individual is entitled to more than one enhancement factor, those factors are simply aggregated."

This is because it may be that a pension credit member is awarded a credit of rights that have already been tested against the (member's) lifetime allowance.

"In those circumstances", the article says, it would be unfair if they prompted a lifetime allowance charge on the pension credit member.

There are three rules applicable: 

1) If the pension credit was awarded after 5 April 2006;

2) and when it was awarded, it was in payment to the member;

3) and the member became entitled to the pension after 5 April 2006 (so it was subject to a benefit crystallisation event),

then the pension credit member will be entitled to claim a pension credit enhancement factor to his or her lifetime allowance. 

The member will suffer a pension debit which will reduce their 'personal' lifetime allowance from the effective date of the pension sharing order rather than the date when rights are actually divided by the scheme.

However, the member could lose out on primary protection and, if they wanted to rebuild their pot and had taken out enhanced protection, they could end up losing their enhanced protection too.

Jessica List, pensions technical analyst for Suffolk Life, comments: "There are more people with lifetime allowance protection now, which could be lost if an investor tries to rebuild their fund.

"Most people will find this very challenging to navigate without an adviser."

simoney.kyriakou@ft.com