A pension can be a great way to plan for retirement. However, they can cause difficulties in separation and divorce. Deciding how much a pension is worth, how it should be divided and what discounts may apply can all be complex issues.
Before a spouse retires and starts collecting a pension, the pension is "property" (like a house or RRPS or other assets) that is divided as part of property equalization pursuant to Part 1 of Ontario's Family Law Act. (Note common-law couples do not equalize their assets on separation and so they have no claims to each other's pensions under the Family Law Act).
Pensions are very valuable assets. Their value is not what the spouse paid into the pension, but the total present value of what the spouse will receive on retirement from the part pension that accrued during the marriage. A spouse will be getting payments of just $2000 per month could have a pension worth half a million dollars! So, prior to changes to the Family Law Act in 2009, where one spouse earned his or her pension during the marriage, it was common for that spouse to get the pension and the other to get the house, which could make life financially difficult for the spouse with the pension.
Since 2009, the most common way that people have dealt with pensions is to divide them "at source." That means the portion of the pension that has to be transferred to the other spouse's pension or LIRA (locked-in retirement account). That decreased the pension payments for one spouse while increasing the money paid to the other spouse on retirement. However, no payments are immediately necessary to deal with the pensions when equalizing property on divorce.
To divide a pension at source after separation, spouses with a provincially regulated pension go to their HR departments, fill out some paperwork, pay a fee (usually $600 per pension) and the pension board calculates how much should be transferred to "equalize" the part of the pension or pensions that accrued during the marriage. Federally regulated pensions can also be divided at source, but the process is a little different. This takes the pensions out of the equalization calculation and all the other property is divided as if there was no pension. That avoids one spouse getting the pension and the other spouse getting everything else.
But sometimes the best long-term financial decision is not to divide the pension at source. Financial advisors helping a separating spouse may advise that the spouse with the pension will be better off in the end if they keep the full pension and get all the full pension payments on retirement. So, one or both spouses may prefer that the pension be included in the equalization calculation and be reflected in the cash that changes hands immediately. If the parties cannot agree on which way to divide the pension, sections 10.1(4) and (5) of the Family Law Act have the effect of making division at the source the preferred way to divide a pension and only allow a judge to order the cash payment in limited circumstances.
Where spouses are going to include the pension in the equalization calculation so as to leave the pension intact, the spouses use the calculations that they got back from the pension board after filing the forms through HR. The pension board gives the value of pension accrued during the marriage, so that is the number to plug into the equalization calculation for the value of the pension. However, that calculation contemplates that the pension will be transferred to another pension or to a LIRA, which means the person who receives the transfer will pay the tax when receiving the payments after retirement. When the pension is not being divided at source, the spouse who is keeping the pension will have to pay all the taxes on the pension benefit payments. So, the tax debt associated with the pension also has to be included in the property equalization calculations.
Essentially that means that the total value of the pension is reduced by the liability. So instead of sharing 100% of the calculated total value of the pension in equalization calculations, only 85%, 75%, 60% or some other amount is shared between the spouses. The reduction takes into account the taxes that have to be paid on the pension benefits payments.
The amount of tax that a person will ultimately have to pay on pension benefit payments is influenced by several factors, such as:
- the size of the pension benefits payments
- what other income the person will be declaring and what impact that has on the marginal tax rate applied to the pension earnings
- what credits or deductions can be applied to reduce the tax on the pension benefit payments
- when the pension benefit payments will start
- what other assets the person may be using during retirement
There is no way to know what the tax liability will be without consulting an accountant or other tax professional. Even then, the liability can change with other changes in a person's life. For that reason, the value of the liability is often "discounted" to take into account uncertainty and the fact that liability will not be incurred for some time. Rather than hire an accountant to do more precise calculations, many people just want to use an educated guess as to what the tax liability will be. For most pensions, the benefit payments will pay the recipient between $44,000 and $50,000 per year, which puts there tax rate at a little over 24%. For income over $48,353 but less than $78,783, the marginal tax rate is just under 30%. So many people just assume that the tax liability will be around 25% of the pension payments.
The 25% reduction is not set out in the law. It is an assumption. The factors above could make it too high or too low. For a person with a modest pension and no other retirement income, or who is a long way from retirement, 25% will too much of a reduction. For people with good pensions, or who have other money for retirement, 25% may be too low.
Getting the number right is something that you should really speak to a lawyer about to make sure the pension is shared at the correct value. Since pensions can be worth a lot of money, the discount can also be worth a lot of money. Speaking to a lawyer to get the numbers right can save you money.
Originally published 07 July, 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.