How pensions are taxed during a divorce

We explore how pensions are taxed in the US and UK, and the tax planning issues encountered in relation to a US or UK pension, during a divorce.

In brief

• The US and the UK have their own tax laws governing the way pensions are taxed.
• Tax could apply to the division of a pension on divorce. There are ways to do this on a tax-deferred basis in the US and UK, requiring separate court orders.
• Different age limits and restrictions apply in each jurisdiction and pensions do not cross borders without tax implications.

How pensions are taxed is a very real concern for someone going through a divorce, as their life savings may well be locked in a pension that they have spent years building up and were relying on to be able to live the lifestyle they are accustomed to during their working lives. When a divorce is being handled through an English Family Court, that Court has jurisdiction over all marital assets, which includes pensions. It is not uncommon for pension rights to be divided or shared to meet the terms of a financial settlement.

The taxation of pensions is complicated, even without crossing borders and dealing with a pension from another jurisdiction. This article explains the basics of how pensions are taxed in the UK and the US, and what special issues may arise in relation to a divorce whether in the US or the UK.

Pension plans take many different forms, whether established by an employer or by an individual, but both countries have their own tax laws controlling the way pensions are taxed. In general, where a pension is a qualified vehicle under the tax code, it means an individual is eligible for tax relief during the contribution phase, with growth and investments protected from tax, until such time as funds are withdrawn and are subject to tax. In the UK, a pension cannot be withdrawn except in very limited circumstances until a person reaches age 55. However, in the US there are penalties for taking funds out before someone reaches age 59 and a half — again with some exceptions. Access to funds in a pension is also severely restricted and generally not possible in the UK, although in certain circumstances, in the US, it is possible to borrow money from your pension up to a certain threshold.

We begin by reviewing the UK tax system for pensions. There was a significant reform to pensions legislation in 2016, the so called pensions freedom legislation which has made it possible to access as much of your UK qualified pension as you wish once you reach age 55. There is a pension commencement lump sum (PCLS) equivalent to 25% of the value of the pension which can be taken tax free if the total value of the pension does not exceed a certain threshold, explained next. The remaining balance is subject to tax as ordinary income at whatever the appropriate graduated tax rate applies in the year the money is withdrawn.

Special rules apply where the value of a pension exceeds a certain threshold, known as the lifetime allowance. For 2021, this amount is £1,073,100 and will remain fixed at that amount until 2026. If a pension is worth more than this amount, the PCLS is limited to 25% of this amount. Additional tax applies to any withdrawals, the rate of which depends on whether someone takes out a lump sum or places their pension in a separate pot for progressive withdrawal over their lifetime. The rate of tax on lump sums that exceed the allowance threshold is 55% in total and on income drawdown, it is 25%. This is in addition to any normal income tax payable. This is a particularly complex area and specialist advice from a financial advisor is always required.

These rules do not apply to overseas pension plans unless UK tax relief has been obtained on contributions made to any foreign plan. A distribution from a foreign pension plan received by a tax resident of the UK is not eligible for the 25% PCLS and is taxed as normal income at whatever tax rate applies. An income tax treaty with the country where the pension plan is located may change the end result. For example, the tax treaty with the US provides that a lump sum withdrawal from a pension plan, which we take to mean the entire balance in the plan, is only taxable in the jurisdiction where the pension is located.

A UK resident who withdraws all the money from their US pension is only taxed in the US on that amount. On the other hand, a US resident who withdraws all the money from their UK pension is in theory only taxable in the UK on that amount. However, special provision in the tax treaty does allow the US to continue to tax its citizens and residents on that lump sum subject to offsetting the tax with any tax paid to the UK.

We now consider the taxation of pensions in the US. There is no exemption amount equivalent to the UK PCLS in the US, but equally, no special regimes based on the size of a pension. It is worth noting however that there are changes under consideration by the House and Senate relating to the allowable size of a pension, specifically IRA plans, as well as changes to the ability to fund a Roth IRA. A Roth IRA is a completely tax-free pension vehicle, but it will have cost tax at some point to transfer money to such a pension and the amounts available to contribute from after tax funds are relatively low. However, for other types of pensions, to the extent you did not get any tax relief on contributions into the pension — very often with an individual retirement account (IRA) — a portion of every amount withdrawn is not subject to tax based on the ratio of the unrelieved contributions to the total value. Pensions do not have any particularly favourable tax rate. They are taxed as ordinary income based on the tax rate applicable to your situation.

An additional 10% penalty applies to any withdrawals made before age 59 and a half, unless a special exception applies. A special rule does require a beneficiary of a US pension to start withdrawing, at least a required minimum amount, by April of the year following the 72nd birthday, unless they are still working. Residents of a state that imposes an income tax will also be subject to tax in that state on any pension withdrawals. It is worth noting that most states give up the right of taxation on a pension that was earned while the individual lived and worked there but retired to another state, and is no longer considered a resident in the state where the pension was earned.

A US tax resident or citizen overseas, in receipt of a distribution from a foreign pension, is taxed on the distribution in the same way as a domestic pension. The difference will be whether that pension distribution can be taxed in the foreign jurisdiction. In this case, it is likely that a credit for the foreign tax paid will be allowed against the distribution and US tax will only be due if the foreign tax amount is lower than the US. If you are a resident in a state of the US that imposes an income tax, then that foreign pension is likely to be taxed at the state level without any relief for foreign taxes paid. It also may be possible for someone who lives overseas or has only relatively recently returned to the US to retire, if there are old excess foreign tax credits that have not been used and could be eligible to offset the tax on a distribution from a foreign pension plan. There are many variables in this, including whether the individual was able to exclude the growth in the foreign pension from US tax while they were contributing, or equally, was not taxed on contributions made by their employer because of the provisions of a tax treaty. On the other hand, if no tax relief was available in the absence of a tax treaty, they may have already paid tax on the growth in the pension and employer contributions, even if offset by foreign tax credits, and therefore, no tax will arise on the ultimate distribution received.

How does taxation of pensions on divorce work?

Perhaps, we should start with the good news. It is very unusual for a pension that is divided or transferred in a divorce to be subject to tax at that time. It is also true that the pension becomes the property of the recipient and they are then responsible for all the tax consequences arising out of that pension, including paying tax on distributions — as if this were their own pension all along. In the US, this may also extend to relief from the 10% early withdrawal penalty. It also presents the opportunity to reduce or eliminate the issue raised earlier regarding the UK lifetime allowance, since once the pension is divided, each party gets to apply their own lifetime allowance to the balance. The reason no tax arises on a division in divorce is because both the US and the UK have systems in place. Upon the order of a court or through a financial settlement, a pension can be shared or transferred without tax. In the UK, this is achieved through a pension sharing order and in the US, through a qualified domestic relations order (QDRO).

So, what is the bad news? Well, this does not cross borders. A UK pension trustee cannot be bound by a divorce order made in the US calling for the division of a UK pension scheme — it must be an order made in a UK court. Similarly, a US pension trustee will require a QDRO from a local court in the US to divide a qualified US pension plan. It often requires at least one of the parties to be physically resident in the relevant jurisdiction to ask for a court order to divide a pension plan. This is a very complex area that requires expert advice from a Family Lawyer in the relevant jurisdiction.

One exception to this rule relates to a US IRA. It is not necessary to obtain a QDRO to divide an IRA account. It would still require a court order of some kind, but the IRA trustee may be willing to accept a UK court order in a divorce to divide up the IRA. In many cases, if the physical residence of the parties does not permit obtaining a court order, the holder of the pension would have to gain access to their pension plan themselves, by taking a distribution if they needed to fund a financial settlement. They would, therefore, be subject to tax on that distribution, potentially with additional penalties depending on the age of the participant or the size of the pension. However, dealing with taxation of pension distributions, making use of some of the special provisions, such as the UK PCLS, a US Roth IRA or foreign tax credits, may still provide some potential planning for tax-efficient division of a pension plan.