Possible double taxation of pension benefits

With two landmark rulings, the Federal Fiscal Court puts an end to the dispute over the possible double taxation of retirement benefits.

Until 2004, pensions were only subject to income tax at the comparatively small rate, while former civil servants and recipients of company pensions had to pay full tax on their retirement benefits. The Federal Constitutional Court considered this to be unconstitutional unequal treatment and obliged the legislator to introduce new regulations from 2005. The legislature has complied with this mandate with the Retirement Income Act.

Since 2005, therefore, not only pensions but also pension benefits have in principle been fully subject to income tax. In return, however, taxpayers can claim their pension expenses as special expenses. This principle is implemented gradually, however, because pensioners were not able to claim the full amount of contributions made up to the reform for tax purposes. In addition, the tax authorities wanted to avoid an immediate tax exemption of all pension contributions because the tax losses would have been too high.

For pensioners who started drawing a pension up to and including 2005, an amount equal to 50 % of their pension at that time remains tax-free in perpetuity. For pensioners whose pension drawdown begins later, the percentage decreases each year: for pensioners drawing a pension for the first time in 2021, only 19 % of the pension will remain tax-free. From 2040, new pensioners will then have to pay tax on their entire pension. On the contribution side, the transitional rules stipulate that in 2005 initially only 60 % of pension contributions could be deducted as special expenses. This year it is 92 %, and from 2025 all pension expenses will be fully deductible as special expenses.

Since the Federal Constitutional Court also demanded in its ruling that double taxation of income must be avoided at all costs, there has been a dispute since the Retirement Income Act came into force as to whether this requirement is really met. Now, 16 years after the reform, the Federal Fiscal Court (Bundesfinanzhof, BFH) has put a possibly permanent end to the dispute with two landmark rulings.

The BFH adheres to its case law, which has also been confirmed by the Federal Constitutional Court, according to which both the change of system to deferred taxation and the statutory transitional arrangements are in principle constitutional. However, it is also clear to the BFH that double taxation of pensions must not occur in specific individual cases. According to the ruling, double taxation is avoided if the total of the pension inflows expected to remain tax-free is at least as high as the total of the pension insurance contributions paid from the income already taxed.

The BFH therefore did not follow the plaintiffs' view that the depreciation of money occurring between the payment of contributions and the drawing of the pension should be taken into account in the calculation. It saw no basis for this either in income tax law or in constitutional law. As a result, increases in the value of pensions - regardless of whether they are inflation-related or represent a real increase - can be taxed.

The plaintiffs were therefore unsuccessful with their own request in both proceedings. However, for the first time, the BFH has defined precise calculation parameters for determining double taxation of pensions. In doing so, it clarified that not only the annual pension allowances of the pension recipient but also those of any longer-lived spouse from his or her survivor's pension are to be included in the tax-free pension withdrawal.

However, the BFH is convinced that all other amounts that the tax authorities would also like to include in the comparative calculation as tax-free pension withdrawals are not taken into account. They serve other, constitutionally required purposes and can therefore not be used again to avoid double taxation of pensions in mathematical terms. Thus, in particular, the tax-free subsistence minimum is also not taken into account when calculating the tax-free pension withdrawal.

Applying these principles did not result in double taxation for the plaintiffs or for many other existing pensioners. However, double taxation is likely to occur for later pensioner cohorts for whom the pension allowance will be reduced further and further under the statutory transitional arrangements. This is because these pensioner cohorts have also made considerable portions of their pension contributions from taxed income. In addition, the double taxation affects self-employed persons, who do not have a tax-free employer contribution, more than employees, and single persons more than married persons.

The Federal Fiscal Court (Bundesfinanzhof, BFH) immediately clarified a number of other disputes regarding double pension taxation. For example, the BFH generally does not recognize double taxation in the case of pensions from private capital investment products. The income share taxation applicable to these pensions cannot systematically lead to double taxation because the income share determined by law permissibly typifies the interest on the capital repayment for the entire duration of the pension withdrawal. This type of taxation does not require that the contribution payments in the accumulation phase be tax-exempt.

In addition, the BFH ruled that the benefits from a voluntary higher insurance in the statutory old-age pension are taxable together with the regular pension benefits. The BFH considers the fact that these benefits lead to an above-average provision from the statutory pension insurance and were financed exclusively from the insured person's own contributions to be irrelevant. In contrast, the BFH shared the plaintiffs' view that the statutory opening clause, which is intended to prevent the risk of double taxation in the case of high payments into a pension scheme, is, according to the unambiguous wording of the law, only applicable upon application by the taxpayer.

In an initial reaction to the ruling, the Federal Ministry of Finance has stated that although a change in the legal situation following the ruling is unavoidable, it will not be tackled until after the Bundestag elections. As the state is threatened with revenue losses of up to 90 billion euros as a result of the necessary changes, the ministry wants to deal with the issue calmly.