Investing in Germany: A guide to leveraging tax advantages
Tax time is here! If you invested in Germany at all last year, there are a number of deductions you can take advantage of to reduce your overall tax bill. Seamus Wolf from retirement investment fintech Horizon65 explains the important ones you should know about.
It is time to report your taxes for the past year. If you feel like you are paying too much in tax, you are not alone. In this article I want to share a few ways you can lower your taxes by taking advantage of tax deductions when it comes to investing.
But first off, what are tax deductions and how do they work?
Tax deductions in Germany
The German government taxes your income to deduct costs for public services. Most people understand income as a synonym for your paycheck at the end of the month - or any other money that comes in - but the government actually has a different definition of it, which we call taxable income. This is your total income minus any deductions. It is this figure that is taxed at the applicable rate to result in your overall tax bill.
With tax deductions, you can reduce your taxable income (and your final tax bill) by explaining that some of the money you received was not actually income because you needed it to pay for expenses.
There are many ways to reduce your taxable income but in this article, we will focus on how to optimise taxes for your investments.
Which taxes apply to investments?
In Germany, any rental income is taxed under the normal income tax rate (the same as your salary) but gains from buying and selling are classified as capital gains and are taxed with capital gains tax at 25 percent.
If you own stocks or ETFs then you may also receive profit distributions (dividends) which are taxed with the dividend income tax at 25 percent.
The income tax rate in Germany is progressive and can go up to 45 percent, depending on your income.
In this article we will cover:
- Investments in real estate
- Investments in ETFs
- Investments in private pension plans
- Investments in company pension plans
We will not cover direct investments in stocks or bonds as there is essentially no method to optimise taxes for those types of investments.
Investments in real estate
Germans often rent the home they live in. This is not necessarily because they cannot afford to buy, but because of the way the German government taxes real estate.
However, some Germans who rent also own houses, but they rent them out instead - because in this case German tax law allows them to deduct all the house-related expenses from their income, including:
- Property management fees
- Notary and other transaction costs for the purchase
- Maintenance costs
- Property taxes
- Mortgage interest payments
Essentially, buying a house and renting it out and then renting elsewhere is cheaper than living in the house you own.
Investments in ETFs
By far the most popular option for long-term investments, ETFs or stock-listed funds are a cost-effective method of investing in the stock market by spreading your investment across multiple listed companies.
ETFs are a better way to invest than buying individual stocks and funds - at least from a tax perspective - as you don’t pay capital gains tax on any stocks you buy or sell within the fund. However, they do not shield you from dividend income tax.
A little-known rule in Germany is that even if dividends are not paid out by the ETF and are instead re-invested into the fund (so-called accumulating ETFs), you have to report the dividends received as dividend income and pay tax on them, even if the money never actually reached your bank account. When you sell an ETF you have to pay capital gains tax (if you made a profit), which takes away 25 percent of your profit.
Generally, therefore, ETF investing is not tax-efficient. There is a better way to invest in ETFs that we will explain below.
Investments in private pension plans
What are private pensions? Private pensions are a structured way to contribute every month to a plan that invests according to your preferences and gives you an additional lifelong income after you retire. In Germany, as in many other countries, this is very important because governments typically only pay you 50 percent of your working income as a pension.
Germany, however, likes to make things complicated, and there are essentially three different types of private pension plans, which are all treated differently when it comes to taxation:
- The Riester pension
- The basic pension
- The flexible pension
The Riester pension is gradually being phased out because the benefits rarely outweigh the costs of such plans, but it can still be an okay option if you are unemployed, work part-time, or have a large family, as the government subsidises those plans.
The good news is that - unlike ETF savings plans, stocks, bonds or ETFs held through a depot - all private pension plans allow you to invest indirectly. This means that these investments sit within a tax wrapper, which shields you from capital gains tax and dividend income tax.
This is not a tax deduction, per se, but it does help you invest more efficiently as you can reinvest your profits without being taxed.
So, which pension plans have tax deductions?
Contributions to Riester and basic pension plans are tax-deductible. However, the amount differs: with a Riester pension you can contribute up to 2.100 euros per year, whereas the basic pension plan lets you contribute up to 26.527,80 euros per year, or twice that if you’re a married couple.
The basic pension plan is essentially investing from your gross income rather than your net income, and this makes a very big difference, especially for high-income earners. The tax advantage could be as much as 11.000 euros for individuals and 23.400 euros for couples.
How do you claim this tax advantage? Freelancers and self-employed workers don’t need to claim a tax refund, as they can simply contribute to their plan and claim the tax deduction on their tax return to benefit from a lower tax bill. Employees, however, have to file a tax return in order to claim back the contribution that has already been deducted from their salary.
That’s why, for contracted employees, contributing to a company pension system can be overall easier to manage.
Investments in company pension plans
Company pension plans can be done on an individual basis (where you bring your own plan) or are regulated across the company (where you contribute to a company-wide plan). In many cases, the company-wide pension plans don’t allow investing in ETFs but individual plans are more flexible.
While company pension plans have the same benefits as private pension plans when it comes to tax wrappers, they also enable you to claim back a part of your social security payments. The other main benefit is that your employer will automatically deduct this investment from your income, and there is therefore no need to file a tax return to claim the money back.
If your employer does not have a company-wide pension, they are legally obliged to pay into your “bring-your-own” pension plan. That said, the contribution limits are not as generous as with the basic pension, with only 7.008 euros of contributions being tax-deductible per year.
Horizon65 is a fintech that helps people to inform themselves of the possible retirement investments available to them, including the tax advantages they can leverage. Horizon65 is offering a free consultation with one of their experts for IamExpat readers, claim yours now!