Lifetime allowance quirks on divorce
The lifetime allowance, with its multitude of protections, has become a challenge to navigate even at the best of times. This is especially true when set against the backdrop of a pension sharing order.
A pension sharing order (PSO) is the mechanism by which a divorcing client is able to share some of their pension scheme with their former spouse. The annex to the order contains a percentage, which is then used to calculate a monetary amount. This amount is deducted from the client’s scheme (pension debit) and then transferred to a pension scheme in the name of the former spouse (pension credit).
Whether you’re advising the client or the former spouse, there are a few lifetime allowance points to be aware of.
Pension debit client considerations
If the client already holds primary protection, they must notify HMRC, as their primary protection factor will be reduced due to the PSO. If the pension debit reduces the fund value below £1.5m, they will lose primary protection altogether.
Remember that the primary protection enhancement factor is applied to the underpinned lifetime allowance of £1.8m rather than the standard lifetime allowance of £1.055m. Therefore, the loss of protection could be quite severe.
Individual protection works in a similar way, albeit the pension debit is reduced by five per cent for each complete tax year after the date the protection was introduced. Again, if the reduction takes the fund value below the protected lifetime allowance, the client will lose their protection.
Enhanced protection and fixed protection work differently in that a PSO won’t revoke them. Remember, however, that contributions will, so the client would have to revoke their protection if they wanted to build their fund back up again. That said, if the pension debit leaves their fund well below the standard lifetime allowance, it may be worth it.
It’s worth noting as well that if the client’s scheme is crystallised, the lifetime allowance used under that scheme remains with the client, even though they are losing a chunk of their pension to their former spouse. There is no enhancement factor available to the client, nor any way of claiming back the lifetime allowance represented by the funds that were transferred out.
If the client is at risk of losing their protection, they may wish to consider taking benefits before the PSO is granted and while the protection is still intact. The former spouse would be worse off given they would be receiving a pension credit with no tax-free cash availability. However, this could be counterbalanced by the client paying over some of the tax-free cash they received – essentially a form of offsetting.
Alternatively, they might look at negotiating a percentage split that doesn’t reduce the fund value below the protected lifetime allowance, whether that’s £1.5m for primary protection or £1.25m/£1m for individual protection 2014/16. It would be wise here, though, not to push too close to the protected lifetime allowance, given that the value of the pension fund will inevitably fluctuate between the initial proceedings and the point the PSO is implemented, and could leave the client on the wrong side of the line.
Pension credit client considerations
First and foremost, the former spouse does not inherit any protection from the original client. However, if the pension credit derived from a pension that came into payment on or after 6 April 2006, they will be able to claim a lifetime allowance enhancement factor. This effectively boosts the former spouse’s lifetime allowance by the value of the pension credit.
If the former spouse already holds enhanced protection themselves, they cannot receive the pension credit into a new scheme. Instead, it must be received into an existing scheme, otherwise it will not be deemed a ‘permitted transfer’.
Both lifetime allowance protections and PSOs are complicated areas, but with a bit of planning it’s possible to work within the framework to provide good and fair outcomes all round.