Avoid taxes when investing - Vorabpauschale
If you are investing in ETFs or mutual funds in Germany, you may have to pay capital gains taxes on profits this year, even if you did not make any profits. 😱 Why is this so and how to avoid taxes when investing in Germany.
- Accumulating ETFs reinvest income immediately while distributing ETFs pay dividends and other income directly to investors.
- Between 1960 and 2021, the S&P 500 rose by 7.4% without reinvestment of dividends and by 10.7% with reinvestment of dividends.
- The Vorabpauschale is a way to tax hypothetical gains. This is intended to eliminate the tax difference between the two ETF types.
- You can avoid the Vorabpauschale by investing in ETFs via pensions. With these, you do not pay any tax during the pay-in phase.
Are you investing in ETFs or mutual funds in Germany? If so, you may be unpleasantly surprised by a potential tax obligation, even if you haven’t made any profits. This tax, known as the preliminary tax or “Vorabpauschale,” has generated concerns among investors.
In this comprehensive guide, we will delve into the difference between accumulating and distributing ETFs, the rationale behind the Vorabpauschale, how to calculate it, and effective strategies to minimize your tax liabilities. Let’s explore the intricacies of the Vorabpauschale and discover ways to optimize your investments.
Difference Between Accumulating ETFs vs. Distributing ETFs
When investors think about ETF investments, they often come across two main options: accumulating ETFs and distributing ETFs. Although these types of ETFs may have the same underlying assets, their treatment of dividends, interest income, and rental income differs significantly.
Accumulating ETFs follows the strategy of reinvesting this income immediately back into the fund. This approach allows the value of the ETF to grow steadily over time. By compounding the income generated by reinvested dividends, accumulating ETFs offers the potential for significant long-term growth. Investors looking for capital appreciation and maximizing the overall value of their investment often prefer this type of ETF.
Distributing ETFs, on the other hand, take a different approach. Instead of reinvesting income, these ETFs distribute dividends and other income directly to their investors. This distribution gives investors immediate access to the passive income generated by the ETF. This flexibility allows investors to decide how to use the dividends they receive, whether for additional investments, expenses, or other financial goals.
The choice between accumulating and distributing ETFs ultimately depends on your individual investment strategy and financial goals. If you seeking long-term capital growth may opt for accumulating ETFs to benefit from compound interest, while if you seeking immediate access to income you may find distributing ETFs more suitable.
The Power of Reinvested Dividends
Accumulation ETFs are very popular with investors, largely due to the remarkable growth achieved through the power of reinvested dividends. This dividend reinvestment strategy can lead to significant returns over time. To understand the potential impact, consider a study that compares the results of a 10.000$ investment in 1960 with and without reinvesting dividends.
In the scenario without reinvestment, the initial 10.000$ investment would have grown to nearly 800.000$ over a period of several decades by the end of the study (2021). This equates to an average annual return of 7.4%, a remarkable figure that illustrates the growth potential of the investment.
However, the real strength lies in the strategy of reinvesting the dividends, similar to the reinvesting ETFs. Reinvesting the dividends received would have increased the same investment from 10.000$ to almost 5 million USD. This phenomenal growth equates to an astonishing 10.7% annual return and illustrates the significant difference reinvested dividends can make over time.
The huge contrast between the returns in the scenarios with and without reinvestment of dividends caught the attention of regulators. They recognized the potential advantage of accumulating ETFs and sought to address the perceived imbalance in the investment landscape.
Understanding the Vorabpauschale
This led to the introduction of the Vorabpauschale, the federal government reacted to the supposed advantage of accumulating ETFs. The aim of introducing this tax was to create a level playing field in the investment landscape and to promote fairness between the different types of ETFs. By taxing the potential gains generated by accumulating ETFs, the regulators wanted to eliminate the tax differential between accumulating and distributing ETFs (also interesting: 10 ETF investing mistakes).
However, many investors have a different view of the Vorabpauschale. They see it as another creative way for the government to raise tax revenue. The idea of taxing gains that have not yet been realized or paid out is viewed with skepticism, leading to the notion of paying taxes on hypothetical gains. This view has sparked debates and discussions among investors questioning the fairness and rationale behind the introduction of the provisional tax.
While the intention behind the Vorabpauschale may have been to create a fairer investment environment, its implementation and impact have raised concern and divergent views among investors. The ongoing discourse highlights the complex relationship between taxation, investment incentives, and the pursuit of a fair and equitable system.
Calculating the Vorabpauschale
Calculating the Vorabpauschale can be a complex undertaking, but understanding the methodology is essential to accurately estimate your tax obligations. The calculation of this tax is based on specific factors related to the value and growth of your ETF within a given year.
First, the value of your ETF on 1 January serves as the starting point for the calculation. Let’s assume the value is 1.000€. If the value of your ETF has increased to 1.100€ by the end of the year, you will have made a notional profit of 100€.
This notional profit is then multiplied by the base rate, which is set annually by the German Ministry of Finance. This base interest rate, which is currently 2.55% (April 2023), is an approximate value for the expected return on an investment.
The amount resulting after multiplying the notional profit by the base interest rate is then multiplied by 0.7. This calculation produces the Vorabpauschale, which forms the basis for determining your tax liability in respect of the accumulating ETF.
PerFinExs humble opinion on the Vorabpauschale
As far as the input tax is concerned, opinions differ among investors, and we at PerFinEx are among those who question its necessity and fairness. In our view, the tax on notional profits is an unreasonable burden. We find it difficult to understand why additional taxes should be levied on investments that have already been taxed.
We consider it as unfair to tax profits that may never materialize. It is simply unreasonable to impose further taxes on hypothetical profits when investments have already been taxed. We believe that the government’s desire to level the playing field could have unintended consequences, potentially discouraging investment and hindering long-term financial planning.
Strategies to Avoid the Vorabpauschale
If you want to minimize or completely avoid paying the Vorabpauschale, you can use various strategies. The first option is to use the tax-free profit allowance to which all German investors are entitled and which is currently 1.000€ (in 2023). In the initial phase of your investment, this limit may be sufficient to exempt you from advance tax. If your investment account is relatively small, you can take advantage of this profit allowance.
However, if your investments grow and you exceed the tax-free threshold, you need to consider the second option. This is investing in exchange-traded funds within a pension. One of the main advantages of investing in exchange-traded funds through a pension is that they grow tax-free until the funds are withdrawn. This makes them a highly tax-efficient solution for long-term investors.
By directing your investments into a retirement account, you can effectively shelter your returns from the Vorabpauschale. Not only do you benefit from tax advantages in the growth phase, but depending on the pension scheme, you also benefit from additional tax advantages when you pay in or withdraw funds from your pension. With this comprehensive tax-saving strategy, you can maximize your investment returns while minimizing your tax burden.
In summary, the Vorabpauschale on ETFs in Germany has provoked mixed reactions among investors. While the intention behind its introduction was to promote fairness, many see it as an additional burden on their investment activities. It is important that you understand exactly how the tax is calculated and explore possible strategies that can help you minimize tax liability.
If you need help understanding the Vorabpauschale, or with setting up an alternative, e.g. pensions, feel free to reach out to us and book a meeting with us.