Breaking good
Key Points
What is the issue?
The increased popularity of flexible retirement income options adds a layer of complexity when pension assets form part of a financial settlement on divorce.
What does it mean for me?
Family lawyers should be aware of the potential tax implications of a disqualifying pension credit to ensure this is considered when arranging an appropriate financial settlement.
What can I take away?
Understanding the impact of a disqualifying pension credit on a spouse's total pension benefits, including lifetime allowance implications.
Introduction
The power for courts in England and Wales to take account of pension assets on divorce originates from the Matrimonial Causes Act 1973,1 although it is not a necessity that they do so. However, where accrued pension funds represent a significant proportion of family wealth, it becomes essential to fully assess their impact on the overall financial settlement.
Historically, pension offsetting was a more common way of splitting pension assets on divorce. In such instances, the pension member was able to retain the pension assets in their entirety in exchange for an appropriate value of assets to be transferred to their spouse, such as the family home. A key benefit provided by offsetting was a clean financial break.
Two further options for dividing the pension assets are now available:
- Pension attachment order:2 effectively a form of deferred maintenance. It requires a proportion of the member's retirement income and/or death benefit lump sum to be paid to the spouse when the member retires. A significant disadvantage of this option is the lack of a clean financial break, as the spouse with the earmarked benefits has no control over the timing of when the pension benefits will be received. This is dependent on when the pension member chooses to take their retirement benefits.
- Pension sharing:3 where pension rights are divided and some of the pension member's rights are awarded to the spouse as their own independent pension benefits. Similar to offsetting, this option provides a clean financial break.
In recent times, the use of pension sharing has become increasingly popular, which, alongside the availability of flexible retirement income options, can often result in the pension being split to be regarded as a disqualifying pension credit. When this is the case, there may be scope for the spouse receiving the credit to receive an enhancement to their lifetime allowance.
Family lawyers will often engage the services of an actuary to value the pension benefits in determining the appropriate financial settlement. Where a disqualifying pension credit is involved, consulting a suitably qualified pensions expert to fully determine the extent to which the pension credit impacts the overall member and spouses' respective benefits should be considered.
Disqualifying pension credits
A disqualifying pension credit is a pension credit received from a pension that is in payment at the time the pension sharing order is granted, and where the pension came into payment after 5 April 2006.
The pension fund would have already been tested for lifetime allowance purposes in the hands of the member incurring the pension debit. Subsequently, the spouse set to receive the pension credit would also then have the pension credit retested for lifetime allowance purposes when they come to take benefits from the pension fund in the future. Therefore, the spouse may be able to claim an enhancement to their own lifetime allowance limit on receipt of the pension credit.
The legislation pertaining to pension credit rights applies under s.220 of the Finance Act 2004. To claim the increase, a completed form must be sent to Her Majesty’s Revenue and Customs (HMRC) no later than five years after 31 January, following the tax year when the pension sharing order took effect. HMRC will subsequently issue the spouse with a certificate confirming the enhanced lifetime allowance (pension credit rights) protection. The certificate will confirm the pension credit factor applicable to two decimal places, and the date from which the pension credit factor applies.
Lifetime allowance
The pension lifetime allowance (the Allowance) is the maximum pension pot an individual can build up before being subject to additional tax charges when they come to take benefits from their pension fund. The Allowance is currently GBP1,073,100; however, this reached as high as GBP1.8 million in April 2012. As a result of subsequent reductions in the Allowance limits, there are individuals who would have transitional protection arrangements in place, which secures them a higher protected lifetime allowance that is in excess of the standard amount. The various forms of transitional protection arrangements are as follows; enhanced protection, primary protection, fixed protection (2012, 2014 and 2016) and individual protection (2014 and 2016).
The exact way in which the disqualifying pension credit will impact on the receiving spouse pension benefits is dependent on various factors including the tax year in which the pension sharing order was granted and the Allowance.
How is the pension credit applied?
The pension credit is calculated by dividing the notional pension credit amount received by the Allowance in force in the tax year in which the credit is awarded.
Where the spouse receiving the pension credit has a protected Allowance (i.e., any of the previously stated forms of transitional protection arrangement), they would need to substitute their own Allowance for the standard Allowance when carrying out the calculation to establish the pension credit factor. The factor is then rounded up to two decimal places.
To work out the actual increase resulting from the pension credit factor, it is then multiplied by the underpinned lifetime allowance (see example case study below) depending on the tax year in which the pension credit was awarded when the spouse comes to take benefits in the future.
In all cases, this extra allowance is added to the standard Allowance (or, if higher, the protected Allowance under either fixed or individual protection) to calculate the spouses revised total pension Allowance limit following receipt of the pension share.
Case study
Background
An ex-spouse became legally entitled to pension credit rights in November 2015 (i.e., after 5 April 2006). The rights came from a pension fund already in payment. The pension was crystallised in March 2014 (i.e., after 5 April 2006). The value of these rights was GBP792,083. At the time of the pension credit, the ex-spouse had already applied for fixed protection (2014 scheme), hereby securing an Allowance of GBP1.5 million and the standard Allowance at the date the pension credit rights were awarded was GBP1.25 million (for the 2015/16 tax year).
Outcome
The entitlement to a pension credit factor is calculated by dividing the notional value of the pension credit by the standard Allowance in force when the credit is awarded as follows:
- GBP792,083/1.25 million = 0.63 enhancement factor (rounded to two decimal places);
- 0.63 x underpinned Allowance of GBP1.25 million = GBP787,500;
- this is then added to the spouse's protected Allowance of GBP1.5million, meaning a revised Allowance of GBP2,287,500; and
- the ex-spouse has five years from 31 January 2017 to submit form APSS201 to HMRC (i.e., no later than 31 January 2022).
Taking benefits from a disqualifying pension credit
In most instances, access to pension funds is permissible once an individual is aged 55 years or older. Subject to LTA limits, there is typically 25 per cent of a pension pot payable as a tax-free lump sum with the residue available to provide pension income, either by purchasing an annuity or utilising flexible income options.
However, although the disqualifying pension credit will be retested for lifetime allowance purposes and use up a proportion of the spouses’ Allowance, there will be no availability of tax-free cash from this proportion of their pension benefits. Any pension funds accrued independently of the disqualifying pension credit will continue to be ‘ring-fenced’ and enable the withdrawal of tax-free cash in retirement, subject to Allowance limits.
Pension credit acquired prior to 6 April 2006
In the situation where pension credits were acquired prior to April 2006, as a result of a pension sharing order, an enhancement to the spouses' Allowance could be claimed but this must have occurred before 6 April 2009. Individuals who had primary protection, which is a form of transitional protection arrangement, would not have been able to claim any further protection.
This increase is called the pre-commencement pension credit factor. It was calculated by dividing the value of the pension credit4 by the standard Allowance for the tax year 2006/07 (i.e., GBP1.5 million). The increase is then applied to the standard Allowance in force when the recipient of the credit factor takes benefits.
In conclusion, when dealing with pension assets on divorce, it is essential to account for the impact of receiving a disqualifying pension credit on the spouses' overall Allowance and long-term pension benefits.
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