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Tax Basics For (Early) Retirees

The other day a reader asked me if I might write a post about taxes for “Early Retirees” at some point. Here it is! As always the upfront disclaimer: I’m neither a financial nor a tax consultant, and I only share my personal experiences and conclusions. And everything in this post relates to the situation in Germany at the point of writing only.

And one more thing: this article is only concerned with common tax law in Germany. It’s not about some shady tax-evasion schemes. 


Account for taxes when making financial plans for retirement

If you’re thinking about Early Retirement – this actually goes for anyone changing from your paid-working phase into regular retirement – make sure you get all the information relevant to your individual tax situation, and consult a tax consultant if necessary.

This is particularly important if you’ve built up a variety of income streams that are treated differently tax-wise. Maybe your income streams start or increase in a staggered way, when you paid off a bank loan on a rental apartment resulting in a higher monthly cashflow for example, or when a pension payment starts. That’s actually the case for us, and I’ve phased our financial plan for retirement accordingly.

Against this background, calculating tax implications might feel a bit like 3-D-chess. You effectively have to gross up what you estimated in terms of necessary monthly expenses, and there might be a bit going back and forth involved. But don’t shy away because it sounds complicated – you can definitely do it!


Watch out for changes in legislation

If you’re currently significantly younger than 50, it might be worth bearing in mind that the official retirement age might be moved up further. When I started working, it was on the assumption that I would be able to draw the full statutory pension at age 65. At that point, women were able to retire with their full pension at age 63. If I want to do this today, I will have to accept a deduction of 14.4% from the pension I will only fully receive at the official retirement age of 67 nowadays.

Intermittently legislation was changed several times, and periods of attending university are not eligible for pension credits anymore for example. Since Germany’s statutory pension is not a fully funded system, but one in which current payers finance retirees, adjustments within the system can only be made via cutting benefits or increasing contributions. The trick out of this is transferring tax money into the system, which is quite a perversion of the idea. As demographic forecasts for Germany are very unfavourable at this point, I’m pretty sure we’ll see more changes in this area in the future. And it’s not a problem of the German statutory pension system only either, the US or France are only two other examples.


Future pensions will be fully taxed

Why is the statutory pension important for you in the tax context we’re talking about? If you’re official retirement age falls from 2010, your complete statutory pension will be taxed. At your personal tax rate. So at that point you might want to rethink the structure of your income streams. To give one example: If you have a rental apartment, you could decide to turn the taxable cash-flow from rents into tax-free cash if you’ve owned the apartment for more than 10 years.

To make tax implications for (Early) Retirees a bit more relatable for you, I’ll run you through our own mix of “passive” income streams. If you’ve not read the linked post: We plan to fund our expenses basically from insurance payouts, rents, dividends, and statutory pension payments.

Your individual mix will obviously look different. But this way, you get some basic insights, and can do your own research from there. If you have concrete question on this, feel free to contact me at kontaktieren.


Tax-free payout of insurances

Upto 2004, buying whole life- and private pension insurance was tax-incentivized, as long as you held them for a minimum of 12 years and opted for a one-time payout instead of monthly pension payments (In the case of monthly payments, only the capital gains were taxed). Generally it’s not a good idea at all to mix insurance and wealth-building in one product, especially not given the historically low guaranteed interest rates. 

But if you do still own one of the old contracts, and can claim the one-time-payout tax free, this might come in handy as a cash-base at the start of your (early) retirement. Or if you’ve got more than one of these old insurance policies like us, it could even provide a tax-free cash-ladder. You could use this cash directly for your monthly expenses, or it could serve as a buffer, compensating potential fluctuations in income from other assets.


Use your right to tax deductions

Apart from this cash ladder, we’ll be funding the “early” phase of our retirement mainly from rental cash-flow and dividends. In Phase 2 we’ll be drawing our statutory pension – which will obviously be lower than if we’d worked up to age 67. All of these will be taxed.

There’s a general tax deduction for everyone which is equal to the “Existenzminimum” (“minimum necessary to exist”). In 2020 this amount is set at 9,408 Euros for a single, for a married couple it’s double this figure. On top of this you can deduct health insurance premiums. If you’re privately insured, the maximum amount deductible is determined by your policy’s components that represent the level of health insurance someone in the statutory system receives. This can nevertheless amount to quite a substantial number.  The bad thing is that you do actually have to to pay the full amount of this yourself also, but you benefit from the full deduction as well – which will probably be way more than the 1,900 Euros that are deductible for “other ‘Vorsorgeaufwendungen” otherwise. (The amount deductible will change again, when you draw the statutory pension where the health care contributions are shared again). If you pay 500 Euros for your “Basisabsicherung” for example, this amounts to 6,000 Euro per year. Add this to the non-taxable “Existenzminimum”, and you’re at 15,000 Euros per year before income taxes are due.

If your statutory pension is fairly high in Phase 2, you might nevertheless fly past these deductions quickly, even find yourself in the upper regions of our progressive tax system, given your total income. On (no affiliate) you can get a good idea, how much tax is due for every additional Euro income, and how you will be taxed on average. Why not check this out right now for the current estimate of your statutory pension.


It’s about your mix of income streams

As I said, this is about income that get’s taxed with your personal tax rate. But before you actually draw from the state pension system, the mix of income sources that funds your expenses might be such, that your personal tax rate is not applicable for the total cash that flows into your account. When you live off the cash-flow from rental apartments for example. Or off dividends, or off a mix of both, like us.

Why’s that? If you rent out an apartment you don’t have to pay taxes on the rent total, but “only” on the profit. To calculate your profit, not only actual costs related to the rental apartment are deductible but also the calculative depreciation on the purchase price of the building. And “Kapitalertragsteuer”, the German tax on dividends and capital gains from stock and ETF investments is only flat 25% – above an annual tax deduction of 801 EUR per person while the the highest tax rate in the standard progression is 42%, or 45% if you’re in the league of the “Reichensteuer” (all currently plus “solidarity tax” and church tax if applicable, the current government plan is to keep the “solidarity tax” on dividends and capital gains).


“Günstigerprüfung” for capital gains

If you live primarily off capital gains and/or dividends, and your personal tax rate stays below 25% this way, you can opt for the “Günstigerprüfung” with your income tax declaration. This means the tax authority will apply the lower tax rate, and you will receive a tax refund. From my understanding the progressivity proviso still applies. That’s if your had an annual dividend and capital gains  income of 20,000 Euros, and no other taxable income, this would still result in the 20,000st Euro be taxed at the marginal rate applicable in the normal tax table.

Oliver at has tackled this in an an article as well, and there has been quite a discussion around it. But for any definitive answer you should consult a professional tax advisor. Der Privatier Peter Ranning has also put together a lot of material around taxes and Early Retirement  here ).


How about tax-free income from a mini-job?

There’s another – admittedly non-passive – way to realize a tax-free income stream in (Early) Retirement as well, the “450-Euro”/”Mini-Job”. If you’re fed up with a full-time job but would like to keep a bit of work structure in your life, this might be interesting to explore. This type of job is usually paid around minimum wage. But some employers offer attractive benefits, like subsidized public transport passes or employee discounts. A possible win not only on the income, but on the expenses side of the equation as well.

On top of that you could use a Mini-Job to bolster up your statutory pension benefits. This could be an interesting option if you’re below certain claim thresholds. I don’t have a Mini-Job, but I do voluntarily make the minimum contribution currently, to ensure I will have the option to draw my pension benefits from 63. 

This is conditional on having 35 years of qualified credits. Another case where this might become relevant: if you and your partner want to opt for “Rentensplitting” (which is possible for married couples and registered partnerships, each partner individually has to meet a threshold of 25 years of personal credits.


Take taxes into account with your planning

When you dig deeper into our tax system you can see why it might be interesting to end up with a mix of income streams that keep you in the lower level of the progression. (Unfortunately not as interesting as in the US, where there is no continuous progression within each tax brackets. That’s an important difference to be aware of if you read or listen to tax planning advice on US blogs and podcasts).

If you’re FIRE-plan is quite frugal that’s possibly a luxury problem anyway. But if you’re leaning more towards the fat FIRE side, or if you’re counting on a large pension from the state system, it really makes sense to include tax planning into your (Early) Retirement set-up.

Financial Independence Rocks!

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