German Pensions Level 1
Pensions level 1 offer by far the highest tax benefits of all German pensions. And that's just one of many benefits of pensions level 1. But these benefits don't come for free ...
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Introduction: Pensions Inside Level 1
Pensions in Germany can be a great way to save money for your retirement. Many expats living in Germany ask themselves if they should get a German pension, and if so which pension scheme the correct one for them is. That is why we will take a look at the advantages and disadvantages of pension level 1 as well as typical scenarios who might want to get a pension level 1 in this article.
Most of you reading this article will be enrolled in the German public pension (“Deutsche Rentenversicherung“) that is in level 1 of the German pension system already. As all employees in Germany have to pay into the German social security system, employees pay 18,6% of their gross salary for the German public pension (split 50/50 with their employer). The maximum salary the German government is charging public pension is 85.200€/year in 2022. Gross salary that you earn above the threshold is free of public pension contributions. That is a maximum contribution of 1.302,60€/month.
What are you getting for that enormous amount of money? Nobody really knows and your future pension can only be estimated with the status letter the public pension is sending you every year. As the German public pension is a generational contract, you are not saving the maximum of 1.302,60€/month for your own retirement. All contributions of the current workforce are spent immediately on the pensions of the previous generations. And upcoming generations will fund your public pension with their contributions.
Meaning the 18,6% of your gross salary that is deducted from your payslip every month is neither saved nor is it invested on your behalf. As the money is paid out in pensions immediately, there is no rate of return, no compounding interest, and no capital growth happening. That is the reason why the government had to support the public pension with almost 115 billion € last year – by far the highest expense of the German government.
The base pension (“Rürup Rente“) is also in level 1 of the German pension system. With the base pension being a private pension scheme between you and a German pension company, the German government is (luckily) not involved here. You can decide freely how much you would like to contribute to your base pension level 1 and everything that you do contribute will be invested for your future pension and your pension only. Your savings are not shared with anyone else.
That ‘small’ difference between the public pension and the base pension allows you to invest your pension contributions in ETFs & mutual funds in the base pension. If you are 27 years now you will retire in 40 years with the age of 67. The base pension will use the full power of compounding interest over 40 years that your pension contributions can accumulate and grow. 40 years the German public pension is missing out on.
Advantages Of Pensions Level 1
German pensions level 1 offer multiple advantages that other pension levels might not have. The first advantage is that the base pension will allow you to invest your money in ETFs and mutual funds (the public pension will not because of the generational contract). Depending on the pension company and the exact pension scheme that you are choosing you cannot just choose your investments yourself, you can also change your investments free of charge and free of capital gains taxes.
That is the real advantage of investing in pensions compared to investing in a regular investment account with a broker. Pensions shield you from paying taxes until you take money out of the pension scheme. Even if you change your investments and sell ETFs or mutual funds with a capital gain, you will not pay any taxes under the pension umbrella.
Another advantage of pensions (level 1) compared to regular investment accounts with brokers is that pensions can never run out of money. No matter how much money you saved in your investment account, you can be in big financial trouble if you live longer than expected and did not save enough. How do you plan to pay for food, housing, and health insurance if you run out of money? Pensions level 1 pay a life-long pension that will pay until the month that you pass away. If you ran in theory out of money and live longer than expected, it is the problem of the pension company and not yours.
The life-long pension payments from German pensions level 1 offer another advantage that you do not need to take a lot of care of your financial planning. Before the retirement age of 67, your employer will pay you a monthly salary and after the age of 67 pensions level 1 will pay you a life-long pension. If you saved enough, your retirement will be just fine.
In case you decide to retire in your home country, the base pension level 1 will also pay you a monthly pension no matter where you are in this world. You will also receive the same pension amount that you would be getting if you would retire in Germany. The German public pension handles retirement outside of Germany differently and might pay you a lower pension if you decide to retire in a country with lower living costs than Germany.
With pensions level 1, it is not just your retirement that is safe. All your pension contributions are also safe from seizure in case someone is suing you and you have to declare bankruptcy. As you are required to pay for all damages that you cause to third parties, bankruptcy can happen faster than expected in case you cause big damage that you cannot pay for. A private liability insurance will protect you against third party claims and that is why this insurance is 1 of the 3 must-have insurances in Germany (others are public or private health insurance as well as the disability income insurance).
The last advantage of pensions level 1 is a big one: Contributions up to 25.639€ are tax-deductible for singles, married couples can deduct up to 51.278€ (twice as much) from their taxes when filing their tax declaration. When investing the maximum of 25.639€ (in 2022, which will rise in the years after) in pensions level 1 with a marginal income tax rate of 42%, you will get 10.768€ in tax money back from Finanzamt after your taxes are filed. That is an incredible rate of return when you only have to save 14.871€ (25.639€ pension contributions – 10.768€ tax refund) in order to invest 25.639€ for your future.
Disadvantages of Pensions Level 1
As there is no perfect pension, pensions level 1 have to have disadvantages as well. We determined earlier in the advantages of pensions level 1 that your contributions are tax-deductible up to 25.639€ in 2022. If you can save taxes while contributing to your pension level 1, your monthly pension will be taxed of course. Finanzamt will not let you get away with paying 0 taxes. The idea behind deferred taxation is that your tax rate while you are working is much higher than your tax rate in retirement. So you would save in contribution e.g. 42% taxes and pay e.g. 20% taxes when receiving your pension.
The tax benefits mentioned in the advantages do not come for free (tax-deductible contributions & tax-deferred growth of your investments). You have to pay for these benefits with commitment. There is no possibility to get your money out before retirement age. As the German government is supporting you with tax benefits throughout your whole contribution phase, they want to make sure you use that money to fund your retirement, so you will never be in need of social security. That is why the only way to receive money from pensions level 1 is a monthly pension in retirement age until you pass away.
Since nobody can withdraw money from pensions level 1 before retirement, you also cannot use your base pension as collateral to purchase real estate with it. Banks are looking for lump sum payout options before accepting pensions as collateral. That is why you can utilize pensions level 2 as collateral for your home (not for investment properties), and pensions level 3 for all kinds of properties (either home or rental). Pensions level 1 are designed to be pensions – and pensions only.
Pensions level 1 cannot be terminated unlike all other pensions in Germany (again, because of the high tax benefits). Of course, you can stop contributing to your base pension level 1 at any time, but the money you invested will stay in your base pension until retirement (earliest with 62 years of age). Money invested in pensions level 1 will stay in the respective pension until you can receive a monthly payout from it. If you stop contributing, your investment will still be invested and continue to grow tax-free until you retire.
The last disadvantage of pensions level 1 is that there are very bad pension plans from bad pension companies on the German market. Given that we compare different pension providers and their products there is really no other way to put it. In theory, it is supposed to be possible to change your pension company, but as you can imagine it is not easy. So pay attention to the following before selecting a base pension level 1 for yourself:
- Choose a pension company that offers a lot of different ETFs and mutual funds to choose from (big investment portfolio)
- Select a pension plan that allows you to select your investments yourself (do not let the pension company pick investments for you)
- Choose a low-cost pension provider that charges around 1% in costs (4% in costs will bring you no value)
- Select a pension provider that is financially stable. You want this pension to live longer than you so they can pay your pension.
If you would like to get some help in choosing the right pension company and pension plan for yourself, feel free to secure a free meeting with us or text us on WhatsApp. We will help you find the best pension level 1 on the German market that suits your life the best.
Conclusion: Who Should Get Pensions Level 1?
Given the advantages and disadvantages you can see that you can save a lot of taxes with pensions level 1, but they definitely lack in terms of flexibility. So if flexibility is important to you, pensions level 1 are not the right type of financial product for you. To give you some inspiration on which scenarios pensions level 1 can be great, here are 3 examples of expats living in Germany:
- People in the highest income tax bracket receive the most benefits from tax-deductible contributions of pensions level 1. Therefore, high earners with +60.000€/year gross salary (or married couples with +120.000€/year) might want to consider pensions level 1 as they pay a marginal income tax rate of 42%. High earners will get 42 cents from Finanzamt for every Euro they invest in their pensions level 1.
- If you would like to protect your ability to work with a disability income insurance, combining this insurance with a base pension level 1 will help you save some money on the insurance premium. As pensions level 1 are tax-deductible, insurances that you combine with pensions level 1 will also become tax-deductible. So far for the upside. The downside is that the disability pension from your disability income insurance will be taxed in case you are disabled. You can insure a little higher disability pension to offset the taxes you would have to pay.
- Self-employed people and business owners can choose freely if they want to pay into the German social security system (including the German public pension) or not. Many decide to not pay voluntarily and rather get private alternatives instead as these are more efficient than government solutions. A base pension level 1 that allows you to invest your money will be a lot better in most cases than paying voluntarily into the German public pension.
These are 3 perfect scenarios for people who might want to consider getting a pension level 1. In case none of these scenarios fits you, you can still get a (base) pension level 1 of course. Think this decision through carefully, because remember: money invested in pensions level 1 will stay in the pension until retirement age. If you would like more flexibility, pensions level 2 or pensions level 3 might be more for you.