Income tax

Definition of

Income tax is a direct tax levied in Germany on the income of individuals. It is an important source of revenue for the government and is used to finance public services. These include, among other things, the maintenance and expansion of infrastructure and the operation of the healthcare system.

Principles of Income Tax Law

The Income Tax Act (EStG) serves as the basis for the collection of income tax. It is based on five principles designed to ensure fair taxation:

The Principle of Ability to Pay: This principle states that the tax burden is determined in accordance with the taxpayer’s ability to pay. Taxpayers with higher incomes bear a greater tax burden than those with lower incomes (vertical equity). Individuals with roughly the same income are subject to the same tax burden (horizontal equity).

Principle of Individual Taxation: Under this principle, income is attributed to the person who earned it. This applies regardless of marital status. Even for married couples, the income of both spouses is calculated separately, even if they file a joint tax return.

Market Income Principle: According to this principle, only income derived from participation in economic activity is subject to taxation. Inheritances, for example, are therefore not subject to income tax.

Principle of Periodic Taxation: This principle states that the tax base is always determined for the same time period. Therefore, income tax is assessed annually.

Worldwide Income Principle: Under this principle, the total income of a person subject to unlimited tax liability in Germany is subject to German income tax, even if it was earned abroad.

Who is subject to income tax?

With regard to income tax liability, a distinction is made between individuals subject to unlimited income tax liability and those subject to limited income tax liability.

Pursuant to Section 1, paragraph 1, sentence 1 of the Income Tax Act (EStG), individuals who have a domicile or habitual residence in Germany are subject to unlimited income tax liability. This means that they must pay income tax in Germany on income earned both in Germany and abroad.

Pursuant to Section 1(4) of the Income Tax Act (EStG), natural persons who have neither a domicile nor their habitual residence in Germany but who earn domestic income as defined in Section 49 of the Income Tax Act are subject to limited income tax liability. In such cases, only the domestic income is subject to taxation in Germany, not the worldwide income. This applies, for example, to retirees who move abroad permanently but continue to receive a German pension.

Types of Tax Assessments

The method of assessment determines how the tax liability of taxpayers is calculated. There are two types:

Individual Assessment: The standard procedure is individual assessment, in which each taxpayer is assessed separately. This means that only the income earned by that taxpayer is taken into account.

Joint Filing: Spouses or registered domestic partners can file their taxes jointly, provided that both individuals are subject to income tax without restriction. First, the income of both individuals is determined separately. Then, the so-called “spousal splitting” method is applied, in which the incomes are added together and the total is then divided in half. As a result, both partners have the same taxable amount. This can offer tax advantages, especially when there are significant differences in income.

Types of Income Under Income Tax Law

Section 2, paragraph 1, of the Income Tax Act (EStG) specifies which types of income are subject to income tax. According to Section 2, paragraph 2, of the EStG, these are divided into profit income and surplus income.

The two groups differ in how their height is determined.

For profit-based income, the profit is determined by subtracting business expenses from total business revenue. For surplus-based income, only the income-related expenses and business expenses associated with earning the income are deducted from total revenue. This calculates the surplus income.

Income from gains includes:

Income from agriculture and forestry: This refers to income derived from agricultural or forestry activities, such as animal husbandry or crop farming.

Income from business operations: This refers to income derived from commercial enterprises such as craft or industrial businesses.

Income from self-employment: This includes income earned by self-employed individuals, such as tax advisors or doctors, as well as income from other forms of self-employment.

Surplus income includes:

Income from employment: This includes compensation for work performed as an employee, such as salaries, bonuses, or other forms of compensation.

Income from capital assets: This refers to income from financial investments, such as interest, dividends, or capital gains from the sale of securities.

Income from renting: This includes income such as rent earned from renting or leasing buildings or land.

Other income as defined in Section 22 of the Income Tax Act (EStG): Other income includes, among other things, recurring payments such as pensions or alimony.

Calculation of Income Tax 

Income tax is calculated in several steps:

1. Determination of taxable income

To determine income, all income that is taxable under Section 2(1) of the Income Tax Act (EStG) is first identified and added together. All deductions that are tax-deductible are then subtracted from this total. These include, among other things, income-related expenses, special expenses, and tax-exempt allowances, such as those for mortgage interest or charitable donations.

2. Setting the Tax Rate

The basis for calculating the income tax rate is the annual taxable income determined in the first step.

If your income is below the basic exemption amount—which, in 2024, is 11,604 euros pursuant to Section 31a of the Income Tax Act (EStG)—no income tax is due. Income above this amount is subject to the following tax rates pursuant to Section 32a of the Income Tax Act (EStG):

- for amounts between 11,605 euros and 17,005 euros: 14 percent to 24 percent

- for amounts between 17,006 euros and 66,760 euros: 24 percent to 42 percent

- for amounts between 66,761 euros and 277,825 euros: 42 percent

- 277,825 euros and up: 45 percent

3. Calculation of Income Tax

The amount of tax is calculated by applying the appropriate tax rate to the taxable income. To do this, the income is multiplied by the tax rate.

4. Solidarity Surcharge

In addition to income tax, a supplementary tax—known as the solidarity surcharge—may be levied. This amounts to 5.5 percent of the calculated tax and is levied only if the income tax exceeds a certain amount. The threshold is 18,130 euros for individual tax assessments and 36,260 euros for joint tax assessments.

Payment of Income Tax

How income tax is paid depends on the type of income. For income from employment, taxes are withheld directly by the employer. Withholding taxes on interest, dividends, and certain capital gains are also withheld directly at the source of payment.

If taxpayers have other sources of income, they must file an income tax return. The tax office uses this return to determine the amount of income tax due and collect it.

In Germany, self-employed individuals and freelancers are generally required to make quarterly tax prepayments. The tax office estimates the amount of the advance payments based on the most recent tax assessment. At the end of the fiscal year, a tax return must be filed to determine the actual amount of tax owed. Depending on whether the payments made exceed or fall short of the tax owed, this may result in an additional payment or a refund.

Tax Return Deadlines

A tax return is a written statement by a taxpayer regarding his or her income situation. If certain conditions are met, filing a tax return is mandatory. According to Section 46 of the Income Tax Act (EStG), this is the case, among other things, if a taxpayer has income not subject to withholding tax totaling more than 410 euros, or if a taxpayer has received wages from multiple employers at the same time.

If you are required to file an income tax return, you must meet certain deadlines to avoid penalties. The income tax return for the previous calendar year must be filed with the tax office by July 31 of the following year. Under certain circumstances, you can apply for an extension, which postpones the filing deadline to a later date. For example, if the tax return is prepared by a tax advisor, the deadline is generally extended to February 28 of the year after next. 

Violations of the Income Tax Act

Section 50e of the Income Tax Act (EStG) lists administrative violations of the Income Tax Act. These include, among other things, late filing of tax returns, failure to pay taxes by the due date, and intentional misrepresentation.

Depending on the nature and severity of the violation, various legal consequences may result, including fines, interest on outstanding tax amounts, or criminal prosecution. In serious cases, tax evasion can also lead to prison sentences. It is therefore advisable to meet income tax deadlines and provide accurate information to avoid legal consequences.

Tax Optimization Strategies

In Germany, taxpayers have various legal strategies at their disposal for tax optimization. The goal of these measures is to take advantage of tax benefits to reduce the tax burden. This includes choosing the right tax brackets, taking advantage of tax deductions, and planning income and expenses within tax-saving models. For example, investing in tax-advantaged plans such as the Riester pension or a company pension plan (bAV) can reduce the tax burden. The same applies to the use of tax-exempt allowances, which allow certain types of income to remain tax-free up to a specified amount. Lump-sum allowances work in a similar way, although they are recognized as tax-free by the tax office without requiring proof. Examples include:

Tax-Exempt Savings Allowance: For individuals, 1,000 euros of income from capital assets is tax-exempt; for jointly assessed taxpayers, the amount is 2,000 euros.

Flat-Rate Deduction for Work-Related Expenses: Work-related expenses, such as commuting costs to the workplace, are deducted at a flat rate of 1,230 euros on your tax return.

Flat-Rate Relocation Allowance: For work-related relocations, individuals may claim 964 euros, plus 643 euros for each additional person moving with them.

Another tool for tax optimization is the loss carryforward and carryback, which are used to offset losses against income from other years in order to reduce the tax burden.

Under the loss carryforward provision , losses incurred in one year are carried forward to the following year or years. The taxable income for those years is reduced accordingly. For example, if a taxpayer incurs a loss of 10,000 euros in 2024, this amount can be offset against their income for the years 2025 and 2026. This reduces the tax burden in those years, and the taxpayer pays less income tax.

Loss carryback, on the other hand , allows losses from one year to be offset retroactively against the previous year’s income. This reduces the tax liability for the previous year, and a tax refund can be claimed. In the example above, the loss from 2024 could be used to reduce the taxable income from 2023. This can result in a full or partial refund of the income tax paid for 2023.

Whether it makes more sense to carry back a loss or carry forward a loss depends on individual circumstances. Carrying forward a loss is particularly suitable if higher income is expected in the coming years and the goal is long-term tax relief. Carrying back a loss, on the other hand, can be advantageous when there is a short-term need for additional liquidity, such as to bridge unexpected financial shortfalls.

‍

‍