How divorcing clients could sidestep a Lifetime Allowance tax charge

According to FTAdviser, the most recent 10-year data shows that divorces fell by 28% in the period between 2005 and 2015. That said, it also shows that 54% of all divorces involved couples aged 60 and above.

Apart from the emotional toll a divorce could have, later in life it’s likely there will be more wealth involved. This is because your clients may have spent decades paying off a mortgage on an expensive home, collected valuable assets over the years, saved and invested money, and built-up significant pensions.

While they may know exactly how much their home, savings, and investments are worth, they may not realise the value of their pensions – despite the fact the retirement funds could be one of the most valuable assets in the marriage.

In some cases, the pension pot could be so large that the holder may be facing a Lifetime Allowance (LTA) tax charge of 25% or 55%. What you may not realise is that if this applies to a client, they might be able to use their divorce settlement to significantly reduce, or even negate, the tax liability.

Read on to discover more.

The LTA limits the amount of pension that has tax benefits

The LTA restricts the amount of tax-efficient pension savings an individual can accrue in their lifetime. In the 2021/22 tax year that amount is £1,073,100, meaning anything above it might be subject to a 25% tax charge if it’s taken as an income, or a 55% charge if taken as a lump sum.

Furthermore, the chancellor froze the LTA until 2026 when he delivered his March 2021 Budget. This could mean your clients are at greater risk of being caught by the LTA tax charge as the value of their retirement fund could continue to grow while the LTA remains the same.

If your clients are divorcing, they might be able to reduce the charge

If your client’s pension is close to or above the LTA, agreeing to split it with their ex-spouse in exchange for other assets will reduce the size of their retirement fund. Doing this might reduce its value to below the LTA, negating any exposure to the tax charge.

To demonstrate this, consider the following.

You have a client with a pension worth £1.5 million in the 2021/22 tax year, meaning it’s £426,900 above the LTA. This could result in them paying up to £234,795 in additional tax should they want to access it, assuming they take it as a lump sum.

Meanwhile, if your client gives their ex-spouse £600,000 of their pension as part of the divorce settlement, they no longer have a pension above the LTA as it will reduce the fund to £900,000. If the former spouse’s pension is valued at £200,000, the settlement will mean they now have a retirement fund of £800,000, which is also below the LTA.

If clients do split their pension, care needs to be taken

Beware that an issue might occur if your client’s ex-spouse has a larger pension pot as well. For example, if the former spouse has a retirement fund valued at £600,000, taking an additional £600,000 from your client’s settlement will take it to £1.2 million, which is above the LTA. This could trigger a tax charge when the former spouse comes to take benefits.

Another risk could be if a settlement increases the value of a former spouse’s pension too close to the LTA. This is because any future growth the pension enjoys might push it over the allowance.

That said, even in this situation your client may still want to consider splitting some of their retirement fund as part of a settlement. To show this, consider what would happen in the above scenario if your client gave £200,000 of their pension pot.

The ex-spouse’s fund would increase to £800,000 which is comfortably below the LTA. While your client’s pension would still be above the LTA, it would reduce to £1.3 million, potentially saving them up to £110,000 in tax charges should they want to access it, based on allowances in the 2021/22 tax year.

Be careful of pension protection

If your client or their former spouse has a protected LTA under the “fixed protection” rules, care needs to be taken. This is because the protection means their LTA could be increased to £1.8 million, £1.5 million, or £1.25 million instead of £1,073,100.

If this is the case, rules apply that mean splitting a pension could result in one of the divorcing parties losing the protection. For example, further contributions or certain types of transfer may result in it being lost.

A financial planner can ensure this does not happen and confirm whether either party has protection they didn’t know about. This could ensure it’s not accidentally lost during a pension split.

Get in touch

Care must be taken when using pension splitting to deal with a potential LTA liability.

As specialists in helping divorcing clients with their finances, you can have peace of mind that anyone we work with will receive the right advice, as well as our award-winning service. If you have clients who you feel would benefit from speaking with us, please email or call 01904 655 330.

Please note

This article is for information only. Please do not act based on anything you might read in this article.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation, which are subject to change in the future.

Get in touch

By talking about your current situation and listening to your aims, we create a personalised plan that will put you on a path to achieving your aspirations.

More articles

12 Feb 2024 News

Why your clients might need guidance from a financial planner when navigating a pension transfer

Read more

12 Feb 2024 News

How a financial planner could help self-employed clients secure their retirement

Read more