German income taxation of US pensions and similar retirement provisions
von Peter Scheller
If expatriates receive pensions or similar retirement remunerations from the US the following tax regulations have to be observed:
- Germany income tax law
- US income tax law
- Double Taxation Convention between Germany and the US (DTC USA)
The same applies if a person receives also retirement remunerations from Germany or other countries.
Unfortunately the definition of terms like pensions or annuities are not the same in German or US tax law and may have another meaning in respective provisions of the DTC USA. This makes it sometimes difficult to qualify a US retirement scheme correctly for German tax purposes.
Another difficulty is the use of different types of retirement plans in both countries. US pension plans often use securities, usual common stocks and bonds and mutual funds as financing instruments. German ways of financing retirement plans traditionally depend on retirement funds, pension insurances or pensions directly paid by employers.
Whether expatriates have to pay taxes in Germany, in the US or in both countries, depends on the character of the pension or retirement remuneration. The DTC USA has various provisions to avoid or minimize double taxation scenarios.
The following criterions have to be considered:
- State or private retirement scheme: Will the retirement remunaration be paid by the federal government, by a federal state, a municipality or official organizations set up by one of these authorities? The most common ones are social security benefits based on the Old Age, Survivors, and Disability Insurance (OASDI). Or will the pension be paid by private employers, organizations, insurance companies or pension plans?
- Legal reason of retirement remunerations: Is the legal reason of the retirement remuneration a former employment relationship? Or is the main reason for the payment the old-age protection or the protection against similar risks such as the permanent inability to work?
- Tax treatment of contributions to pension schemes: Did contributions or payments to the pension scheme being subject to a beneficial tax treatment? Such beneficial tax treatments are for example:
- deductibility of contributions for income tax purposes
- tax exemption of earnings of a pension plan
- tax exemption for contributions to a pension plan by an employer or
- Government subsidies.
US tax law provides respective tax beneficial schemes such as Qualified Retirement Plan (most important the 401k plan), Individual Retirement Account or Individual Retirement Annuity.
- Payment for government services: Is the pension paid for services for the federal government, a state or municipally or one of their official organizations?
Before mentioned factors are important to the question whether Germany or the US have the right to tax certain retirement remunerations (mainly based on the provisions of the DTC USA). However, this does not answer the question how the payments will be taxed. This will be determined only by domestic law. If Germany is allowed to tax US pensions or annuities by the DTC USA, it will calculate tax base and tax rate by its own tax regulations. Germany has a lot of different tax treatments depending on the character of the retirement remuneration.
2. Tax treatment of pensions and other retirement remunerations in Germany
German tax law differentiate between lifelong pensions and annuities, pensions and annuities paid for a certain period of time and other payments such as one-time payments.
Another important issue is whether retirement remunerations are financed by the entitled person itself or paid by an employer as subsequent benefits from an employment relationship. The later requires that the retirement remuneration is granted as compensation for work rendered during active time. These are for example payments of the employer to pension plans. If the employee pays contributions or accepts a salary cut in order to finance a pension or annuity, the retirement remuneration is qualified as a self-financed annuity.
It is also of importance whether the payments are paid regularly with a before determined amount. A regular increase of payments is considered to be regular if it reflects the inflation. Payments are not deemed to be determined and regular, if they can be changed because of the economic situation of the contributor or beneficiary or if the amount depends on reference parameters such as benchmarks.
In German income taxation the term life annuity (Leibrente) is of significant importance. A life annuity requires the following:
- Regular and determined retirement remunerations
- Lifelong payments to the beneficiary
- Not financed by an employer for work rendered during active time
b) Basic retirement remunerations
Retirement remunerations of the following sources are considered to be as basic retirement remunerations:
- Social security pension
- Agricultural pension funds
- Occupational pension schemes for certain professions
- Qualified private annuities (Rürup-Rente)
Although it is not mentioned by German tax law, foreign retirement remunerations which cover the basic retirement care may also qualify as basic retirement remuneration. The US social security pension does so. The same may apply for pensions paid by other official or private bodies if these pensions fulfill the following criteria:
- A certain retirement age has to be reached (e.g. 62 for social security retirement benefits).
- By law the entitlement from the pension scheme cannot be transferred to another person or organization (sale, inheritance, lending) and cannot be capitalized.
- Contributions to the pension scheme must be obligatory by law.
If a US pension or annuity is qualified as a basic retirement remuneration there is a special tax regime applicable. Determining for the tax treatment is the year in which a person is entitled to the pension or annuity or the year the person receives a retirement remuneration for the first time. In the year 2005 only 50 % of the payment was subject to German income tax. This percentage increases up to 2020 by 2% per year and from then on by 1%. In the year 2040 the percentage will be 100%.
Example: A receives in the year 2018 his US social security pension for the first time. If A is tax resident in Germany 76% of his pension will be taxed. 24% will be tax-free.
c) Qualified company and private retirement remunerations
In Germany these are Pensionsfonds, Pensionskasse, Direktversicherung and so called Riester Rente. These schemes are subject to various tax benefits before retirement age (see section 1 - Tax treatment of contributions to pension schemes).
There are different tax treatments for parts of the retirement remunerations:
- If contributions to the plan have been subject to a tax benefit, pensions or annuities will be subject to the regular German income tax.
- If parts of the contributions have not been subject to a tax benefit, pensions or annuities will be subject to a special tax treatment (see section 2.d). This could be the case if the beneficiary was not entitled to a tax benefit or contributions exceeded maximum amounts.
- If parts of the contributions have not been subject to a tax benefit, one-time payments or certain other payments will be subject to another special tax treatment (see section 2.e).
If contributions have been both subject to tax benefits and no tax benefits they have to be split-up (calculated by an actuarial method). For German retirement products this split-up will be provided by the insurance company or organization who pays out the pension or annuity. Foreign insurance companies or pension plans will in general not provide this kind of information. In this case the split-up can be done by splitting-up respective contributions into a part which has been tax beneficial and a part which has not been. However, the split-up may cause practical problems.
German tax authorities see the following US products as qualified US pensions:
- qualified plans under section 401(a) of the Internal Revenue Code,
- individual retirement plans (including individual retirement plans that are part of a simplified employee pension plan that satisfies section 408(k),
- individual retirement accounts, individual retirement annuities, and section 408(p) accounts,
- section 403(a) qualified annuity plans,
- section 403(b) plans, and
- section 457(b) governmental plans.
Roth IRAs under Section 408A are not considered to be qualified in this respect. In general they will allow a special tax treatment (see section 2.d or 2.e).
German tax authorities treat 401k plans as follows:
- Pensions will be taxed as regular income if contributions have be paid from 2008 on.
- Pension have to be split-up if contributions have be paid beforehand.
d) Other life annuities
These are life annuities (definition see section 2.a) and certain other payments as long as these payments are not subject to the tax treatment in section 2.e. Main types of relevant annuities are German state pensions and private pension insurances which are not basic retirement remunerations or qualified private pensions.
Pension insurances mentioned in these section are the ones who do not fulfill special requirements:
- No life-long retirement pension (e.g. disability pension benefit)
- Start of annuity before 62 (until 2011 before 60)
- Withdrawal of contributions (although these payments may fall under section 2.e)
In the year 2005 Germany changed its tax treatment of pension schemes fundamentally. Therefor pensions and annuities which started before 2005 are treated differently to those which started after 1 January 2005. Annuities which started before 2005 are tax free if the contractual duration lasted at least 12 years and other criteria were fulfilled (qualified old schemes).
For annuities which started from 1 January 2005 on or non-qualified old schemes the following tax treatment applies. The pension or annuity will be taxed with a certain percentage. This percentage depends on the completed year of life of the beneficiary.
Example: A is a US citizen and lives in Germany. He is 65 when he first receives a payment from his private pension insurance. 18% of the pension will be taxed. 82% of the pension will be tax-free.
There are special rules if the pension will not only be paid to the insured person but also to certain persons after his death (e.g. surviving spouse or children).
e) Pension insurance with the right to withdraw contributions
If the insured person has the right to withdraw its contributions at contractual maturity date, a special tax treatment applies if
- the contributions and deferred earning will be paid to the beneficiary,
- remunerations will be paid within a certain period of time in installments or
- the pension insurance policy will be repurchased by the insured person.
If a life-long retirement remuneration will be paid the tax treatment of section 2.d is applicable.
This section especially covers one-time payments of pension plans or insurances.
Taxed will be the difference between payments by the insurance company and the total amount of contributions. Only half of this amount will be taxed if the contractual period is at least 12 years.
Special rules apply for endowment insurances (life insurances with payment of the capital stock) and insurance products with special administration rights of the insured person.
Note: Other insurance products which do not grant a life annuity or do not fall under section 2.e will be treated as capital investments. Earnings will be taxed as normal capital income (dividends, interests, capital gains). The tax rate is 25% plus solidarity surplus charge of 5.5% of the tax (total flat rate: 26.375%).
f) Company pensions
All retirement remunerations described in previous sections are annuities and similar retirement payments which are either contribution-financed pension plans or capital-based pension plans. They are either obligatory (like social security benefits) or voluntary (like private pension plans). All of these retirement remunerations are not based on work rendered to a former employer.
In contrary to before mentioned plans, public and private employers often grant retirement entitlements for work being performed at active times. These pensions are directly connected to a former employment relationship.
Company pensions will be taxed in Germany when being paid-out. There is a special deduction which decreases every year. If the pension starts 2018 the following allowances are applicable: 19.2% of the pension, limited to a maximum amount of 1,440 Euro. In addition to that another 432 Euros can be deducted.
g) Taxation of retirement remunerations in Germany
Above mentioned taxable retirement remunerations will be taxed at the progressive income tax rate. The maximum tax rate is 45% plus solidarity surplus charge. However, tax burdens of retired persons are in general moderate if there are no other significant sources of income such as business or rental income. The reasons are:
- Most pensions and annuities will only be taxed by a fraction of paid amounts.
- There is a general tax allowance of 9.000 Euro for singles and 18,000 Euro for couples who choose joint tax assessment (2018).
- There is a special tax allowance for persons over 64 of 19.2% on other income which is not above mentioned retirement income. The maximum amount for 2018 is 912 Euro.
- Expenses connected to above mentioned retirement income can be deducted. The minimum allowance is 102 Euro.
A retired person (single) with a total income of 30,000 Euro will face an overall tax rate of about 19 % (2018). The overall tax rate for a married couple with the same income will be about 8% (joint tax assessment).
Note: If pensions or annuities will be subject to US income tax, US taxes may be credited against German income tax in some cases.
3. Double Taxation Convention
If a US citizen is resident in Germany, he or she always face a potential double taxation scenario. The reason for that is the fact that the USA tax their citizens regardless of their actual residence since Germany taxes individuals with their worldwide income if they are resident in Germany. Double taxation treaties and domestic law provide various measurements in order to avoid or minimize a double taxation. There are various methods to achieve this goal:
- One state taxes a particular income and this income is tax-excluded or tax-free in the other state (exemption method).
- Both states tax a particular income and one state credits the tax of the other state against its own income tax (tax credit method).
- Both states tax a particular income and one state allows the deduction of the foreign tax from its tax base (deduction method).
All above mentioned retirement remunerations (except payments for public services) may only be taxed in the state where a person has its (main) residence (Art. 18 and 21 DTC USA). Therefore US pensions, annuities and other remunerations paid to Germans and citizens of other nations will only be taxed in Germany if they are tax resident in Germany.
These provisions are not applicable to US citizen. The saving clause (Art. 1 (4) DTC USA) allows the USA to tax their own citizens regardless of the provisions of the DTC. This means that a US citizen who lives in Germany will be taxed in Germany because of tax residence and in the US because of citizenship. In most cases the US will credit the German tax against the US tax (Art. 23 (5) DTC USA). This treatment applies for pensions, annuities and similar remunerations such as Individual Retirement Accounts (IRA).
The saving clause is not applicable to social security benefits (Art. 1 (5a) DTC USA). Therefor US social security pension of US citizens living in Germany will only be taxed in Germany. These benefits will not be taxed in the US.
A special provision applies for pensions and other similar remunerations paid by the government, public subdivisions or local authorities in respect to services rendered to one of these official bodies (Art. 19 (2) DTC USA). These are pensions and other remunerations paid to civil servants, judges, military personal and other persons who are paid out of funds of the US government, public subdivisions or local authorities. Pensions and other remunerations will be taxed in the USA only. These payments are excluded from income tax in Germany. However, these payments have to be declared in the German income tax return since they have an effect on the progressive income tax rate.
Note: There may be no double taxation because retirement remunerations will either be tax excluded in one of the countries or the German income tax will be credited against US income tax. In case of a tax credit the higher tax level of both countries will be definite since the USA will credit the German tax on these remunerations only up to the level of the US tax.
Pensions, annuities and other retirement remunerations of US citizens who are resident in Germany will be taxed in Germany. An exception are pensions paid by the US government, states, municipalizes or other official organizations for services rendered to these official bodies.
US social security benefits will only be taxed in Germany and be tax excluded in the US. Other pensions, annuities and retirement remunerations will be taxed in both states if the recipient is a US citizen. The German income tax will be credited against the US income tax.
The difficult task will be the correct qualification of US pensions, annuities and other retirement remunerations for German tax purposes. There is a variety of types of retirement remunerations. The differentiation is of importance since the tax treatment of every type differs significantly. Another practical difficulty occurs if a remuneration has to be split-up.
Author: Peter Scheller, Steuerberater, Master of International Taxation, Fachberater für Zölle und Verbrauchsteuern