Why this year’s reforms make pensions an even more valuable asset in a divorce

couple sitting on a park bench after an argument

Since its introduction in 2006, the Lifetime Allowance (LTA) has restricted the maximum pension benefit that an individual can accrue over their lifetime before a tax charge is made. The tax charge can be up to 55% of the pension value over the LTA.

That was until, in a surprise move in the spring Budget, the chancellor announced he was removing the LTA tax charge in 2023/24, with a plan to abolish the LTA entirely in a further Finance Bill.

So, with no upper limit on the amount of tax-efficient savings an individual can accrue, pensions could become an even more valuable asset to consider when clients come to divorce.

Read on to find out more about how the abolition of the LTA could affect your divorcing clients, and the issues to consider.

LTA has led to complexity when it comes to pension sharing

Historically, Pension Sharing Orders have counted towards the receiving spouse’s LTA, while the person making the pension credit will experience a fall in their pension benefits when tested against the LTA.

So, someone with an existing pension of £800,000 receiving a pension share of, say, £500,000 would have seen their fund exceed the LTA, leading to a tax charge when they came to draw the funds.

This led to increased complexity when it came to pension sharing, often as any LTA tax charge had to be considered when determining how pension funds would be split on divorce.

The removal of the LTA tax charge, and the intended abolition of the LTA altogether, is great news for clients with larger pension funds.

It means that individuals have no upper limit on the amount they can accrue without losing 25% of the value of the fund above the LTA to tax (if drawn as income) or 55% (if drawn as a lump sum).

Tapered Annual Allowance may still restrict the ability to build up significant pension wealth

While there is no longer an LTA tax charge, the Tapered Annual Allowance – which restricts the amount of tax-efficient pension contributions a higher earner can make each year – does remain.

So, any client earning more than £360,000 can typically only pay £10,000 into their pension each tax year without additional tax charges. Clearly this will limit the amount of pension savings the wealthiest individuals can make.

Pension Sharing Orders likely to become more prevalent

The LTA reforms will also likely mean that pensions become an even more valuable asset on divorce.

Simply, the change in the rules will likely encourage more people to put money into their pensions over the course of their marriage. Consequently, upon divorce, the pension may be relatively more valuable than other investments.

Moreover, with no LTA tax charge to consider, the spouse with the pension now has a more valuable asset on a net basis. This means that the amount payable to the other spouse is likely to increase in the case of a divorce.

Older spouses with larger funds may also benefit, as they now have the opportunity to replenish their funds after a Pension Sharing Order without the risk of exceeding the LTA and facing a 55% tax charge.

And, where the paying spouse may have previously been reluctant to share their pension because of the effect it would have on their LTA, the removal of the LTA may encourage more Pension Sharing Orders.

Pensions are also likely to become a more important Inheritance Tax planning tool

Pensions are an excellent way to pass wealth through generations tax-efficiently.

They normally fall outside a client’s estate for Inheritance Tax (IHT) purposes so, if a client dies before the age of 75, a beneficiary can normally inherit the pension tax-free. After age 75 the recipient will normally pay Income Tax on the pension at their marginal rate.

If you have wealthy clients who can sustain their lifestyle through other means, this can have two key benefits.

Firstly, they can deplete their IHT-liable savings and investments through drawing them as income, reducing the value of their estate for IHT purposes.

Furthermore, they can maintain the value of their pension fund, which they can pass down with no IHT charge.

The removal of the LTA means these clients now have the ability to:

  • Accumulate uncapped value within a pension fund
  • Pay no Income Tax until benefits are taken
  • Shelter more wealth from IHT.

And, with no tax charge, clients may decide to continue accumulating wealth for longer, making their pension fund the “pot of last resort”.

This could also add to the value of a pension as a marital asset, and lead to an increase in formal pension sharing.

Of course, this could all change

The one uncertain factor is that pension legislation is often subject to political interference.

Governments frequently tweak rules and regulations and so there is no way a client can rely on these changes to still be in place when they divorce or come to retire.

Indeed, in the aftermath of Jeremy Hunt’s surprise Budget announcement, Labour committed to restoring the LTA should they win the next election.

Get in touch

Changes to the LTA are likely to see an increase in the value of pension assets and, consequently, their importance in a divorce settlement.

To find out how we can help, email info@blueskyifas.co.uk or call us on 0118 987 6655.