Fundamentals of taxes for passive investors

Investing involves accumulating financial assets which may require you to pay additional taxes. You need to comprehend your taxes so you can be aware of your (tax) obligations and avoid paying unnecessary fines. Additionally, an understanding of taxes allows you to reduce them and as a result increase your returns.

The tax laws are different in every country – there isn’t any common European law on taxes – therefore I can’t write a general guide to taxes to every single country. This article aims to give you an overview of the fundamentals which may be common in some countries so you can have a starting point. It does not exclude the need to for you to get to know the specifics around your local taxes. There might be more taxes and aspects to consider (than the ones mentioned here) as you invest.

Dividend taxes

You may receive dividends from your index funds. A dividend tax is a tax imposed on the amount of dividends you received.
For example, if you received 20 EUR in dividends and the dividend tax rate is 25%, you would have to pay 5 EUR in taxes.
Avoiding dividend taxes is one of the primary motivations for buying accumulating funds.

Capital gains taxes

Capital gains taxes are taxes on the profits made from selling your index fund shares.
For example, if you buy one share of a fund for 100 EUR and you sell it for 300 EUR. Your profit was 200 EUR. If the capital gains tax rate is 25%, you would have to pay 50 EUR in taxes.
Usually, you don’t tend to pay capital gains taxes when you sell your shares at a loss (e.g. bought for 100 EUR and sold for 50 EUR). Some countries allow investors to use losses to deduct their taxes across different fiscal years in order to reduce their taxable income.

Different taxes depending on the fund

Different fund types might be taxed at a different capital gains and dividends taxes. An example is Belgium which taxes accumulating equity funds and accumulating bond funds differently.

Tax withholding

Tax withholding happens when the payer of the income (e.g. a broker, a fund) retains the taxes you owe and pays them directly to the government.
In Germany, local brokers do tax withholding. Therefore, you don’t have to pay the taxes to the government since the broker will do that.
In some countries brokers don’t withhold taxes. Therefore, you would have to pay the taxes to the government at the end of the fiscal year.

Fiscal year

Fiscal year is the period used by governments for tax purposes. Different countries may use different periods. In some countries you submit a tax form with your income details at the end of the fiscal year.

Belgium’s fiscal year matches the calendar – from 1st January to 31st December. This means that for the fiscal year of 2017, the government would use all your transactions incurred from 1st January 2017 to 31st December 2017, to calculate your tax liabilities.

The UK’s fiscal year is from 6th of April until 5th of April. Therefore the period to calculate the tax liabilities is different from Belgium’s.

Tax allowance

A tax allowance is a threshold below which you don’t have to pay tax (e.g. dividends or capital gains). For example, if you have received 50 EUR worth of dividends in a fiscal year and the tax free allowance is 900 EUR then you don’t need to pay any tax.
The UK has a capital gains tax allowance.

Tax shelter

A tax shelter is an investment wrapper which allows investors to contribute to funds without being subject to capital gains/dividend taxes. These vary significantly between countries. The UK’s ISA is an example of a tax shelter.

Tax form

A tax form (electronically or in paper) is where the taxes are actually reported to the government. A tax form will have many sections, some of which dedicated to filling investment related information. These sections is where you fill information related to dividends/capital gains you obtained during the fiscal year.

Tax deductions

A tax deduction is a way through which you use expenses made on certain items to reduce your taxable income. Some retirement investment wrappers allow you to deduct contributions made to them from your taxable income. Example: You earned 70k EUR in a fiscal year and contributed 20k EUR to your retirement pension scheme. Instead of income taxes on being applied on the full 70k EUR, a tax deduction would allow income taxes to be applied only on the 50k EUR (70k – 20k).

Notional income tax

Notional income tax is a tax on income that you could have possibly earned but haven’t received.
An example where this is applied is how the UK treats taxation of accumulating funds. You pay dividends tax on the accumulated dividends even if you didn’t actually directly receive them.
For the purposes of index investing, a notional income tax will dictate if the tax treatment of accumulating and distributing funds is similar.

Fund tax reporting status

Tax reporting is the set of processes funds undertake to optimize the taxes of their investors. A few countries (notably the UK and Germany) have special legislation which makes “non reporting” funds taxed at a higher rate. There is a “tax status” section in justETF and you should pay attention to it if you live in the UK, Austria, Switzerland and Germany.

Inheritance taxes

Inheritance or estate taxes are taxes paid by the person who inherits money/property/assets from somebody that has died. One of the reasons why investing in US domiciled funds is not recommended for many European investors is US’s estate tax for non resident aliens.

Tax law changes

Tax law changes all the time. Tax rates, deduction limits, tax calculation methods may change from one fiscal year to the other. You need to not only understand taxes but be wary of any potential changes every year.
For example, at the start of 2018 Germany did a significant overhaul of the way it taxes ETFs.
This also means that any claims about a specific country’s tax peculiarities in this article is only really valid at the time of writing.