Germany's Annual Tax Act 2024 (Jahressteuergesetz) brings tweaks to the country's Income Tax Act (Einkommensteuergesetz). Due to adjustments to Sec. 22 no. 5 sentence 2 of the act, the tax treatment of people receiving retirement income from abroad will tighten significantly. Coming into force on 1 January 2025, the new regulation will specifically have consequences on tax breaks for pension contributions granted under foreign tax law. Following the German parliament's adoption of the draft legislation in October, the Federal Council approved the Annual Tax Act 2024 on 22 November.
Background: Downstream taxation in Germany
The Retirement Income Act (Alterseinkünftegesetz) took effect in 2005. Since then, Germany has followed the principle of downstream taxation when it comes to retirement accounts, i.e. tax is levied when the pension is paid. Pursuant to Sec. 22 no. 5 sentence 1 of the Income Tax Act (hereinafter: ITA), this affects expenses and benefits from pension funds, pension plans and direct insurance policies. In the pension accumulation phase, a person saving for retirement is given preferential treatment in that, for example, contributions are tax-deductible (Sec. 10a ITA) or can be made tax-free by the employer (Sec. 3 nos. 63 and 63a ITA). In return, both the ongoing and one-off payments to the taxpayer in the decumulation phase, when the pension is paid out, are taxable in full in accordance with Sec. 22 no. 5 sentence 1 ITA. However, Sec. 22 no. 5 sentence 2 ITA stipulates exceptions to the principle of full taxability for payments from contributions that are not treated preferentially.
Payments from foreign pension plans are also subject to downstream taxation in accordance with Sec. 22 no. 5 sentence 1 ITA, provided that comparable tax benefits to those specified in Sec. 22 no. 5 sentence 2 ITA were granted. This applies in particular if a double taxation treaty (DTT) provides for corresponding benefits for contributions to foreign pension plans. Until now, however, foreign pension plans have enjoyed privileges over purely domestic plans in certain configurations. If the contributions have been tax-advantaged or exempt from tax abroad, the investment income and increases in value from such plans have been only partially taxed in Germany. In its judgment of 28 October 2020 (case no. X 29/18, DStR 2021, 1213), the Federal Tax Court ruled in favour of the taxpayer over the taxation of payments from a US 401(k) pension plan. The court held that such payments are subject to taxation in Germany only on the difference between the payout received and the contributions made to the plan. This rested on the fact that tax exemptions applied to contributions during the pension accumulation phase abroad do not align with the exemptions outlined in Sec. 3 no. 63 ITA. The broadened scope of Sec. 22 no. 5 sentence 2 ITA therefore leads to a tax privilege for payments compared to the full taxation of payments provided by domestic pension plans.
With regard to earlier cases, i.e. pension plans concluded before 1 January 2005, the proceedings currently pending at the Federal Tax Court under the case no. X R 23/22 should be observed.
Planned changes in 2025
In order to cancel out what the German legislature sees as unjustified preferential treatment, the Annual Tax Act 2024 updates Sec. 22 no. 5 sentence 2 ITA. The effect is that not only the tax exemption of contributions under German tax law but also a comparable tax exemption or benefit for contributions under foreign tax regulations constitutes payments within the meaning of Sec. 22 no. 5 Sentence 1 ITA. Corresponding payments from foreign pension plans (e.g. traditional IRAs, 401(k) plans) will therefore be recognised in full as other income (sonstige Einkünfte) from 1 January 2025. This is despite the fact that Germany did not subsidise the pension accumulation phase and therefore did not lose any taxable income. There is no provision for a partial tax exemption or a limitation of taxable income to the net amount.
Payments from pension plans whose contributions originate from income that has already been taxed remain unaffected by the planned amendment to the law and will continue to be covered by Sec. 22 no. 5 sentence 2 ITA. The taxation of payments whose contributions received tax concessions in Germany also remains unchanged, e.g. in the case of US pension plans, if Germany had the right to tax during the pension accumulation phase and Germany has exempted the contributions from tax or allowed them to be deducted (e.g. Art. 15 and Art. 18A DTT-USA). Such configurations were previously covered by Sec. 22 no. 5 sentence 14 ITA and will now be transferred to the new version of Sec. 22 no. 5 sentence 2 ITA.
Consequences
The planned amendment to the law will significantly tighten the taxation of payments from foreign pension plans. The change is particularly relevant for payments from US pension plans. In the cases concerned, it must be examined whether the tax consequences can be minimised for persons with unlimited tax liability, e.g. by receiving a payment before the new regulation comes into force or after moving away. Conversely, if an individual plans to move back to Germany, the tax advantages of a previous payment abroad can also be assessed. Tax and legal advice should be sought in good time to rule out potential pitfalls.
Originally Published 2 December 2024
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
