Building private assets with ETFs during a period of rising interest rates
Income from investing in ETFs at the fund level
According to the consensus among finance academics, there is a growing number of private investors who are building assets for the long term with maximum diversification and minimum costs by participating in the global equity market. In doing so, they frequently draw on so-called exchange-traded funds (ETFs) that, because of their structure, are usually cost-effective and facilitate flexible investment opportunities without forfeiting diversification.
At the same time, many ETFs track a specific index whereby a basket of securities are held that form the basis of an index and are similarly weighted. The question that needs to be asked here is whether the net income that accrues in the ETF is distributed in the form of dividends or interest paid to investors, or whether it is accumulated.
Please note: Frequently, an ETF will thus offer distributing and accumulating alternatives (so-called ‘sister ETFs).
Income from investing in ETFs at the personal level
A separate analysis of the fund and investor levels was made possible by the 2018 German Investment Tax Reform Act under which, for taxation purposes, the transparency principle was replaced by the separation principle. According to that, investment income at the personal level, pursuant to Section 20(1) no. 3 of the Income Tax Act (Einkommenssteuergesetz, EStG) is subject to withholding tax plus the solidarity surcharge. The Investment Tax Act (Investmentsteuergesetz, InvStG) differentiates here, according to Section 16(1) InvStG, between distributions (no. 1), capital gains (no. 3) and pre-determined tax bases (no. 2). While the first two above-mentioned types of income relate to actual cash inflows at the investor level, the pre-determined tax basis constitutes non-cash income; the latter category was introduced with a view to equalising the tax treatment of distributing and accumulating sister ETFs or funds. The basis for this notional income - which can be deducted if a capital gain is realised - is the rate of return that is specified in Section 18(4) InvStG and has to be modified as well as published annually by the Federal Ministry of Finance in the Federal Tax Gazette (Bundessteuerblatt) at the start of each calendar year.
Low interest rate phase has been replaced ...
As a consequence of the phase of sustained low interest rates, the relevant rate of return before modification was 0.87 %, 0.52 % and 0.07 % respectively for the years 2018-2020. The low point was reached in 2021 and 2022 with a rate of 0.00 %. Low interest rates on the bond markets cannot however be compared with low dividends on the equity market. In the 2018-2020 period, accumulating funds were thus able to benefit from tax privileges on account of lower or no income at the investor level when compared with the distributing alternative because, in the latter case, tax implications were triggered, at least, where distributions exceeded the flat-rate savers’ allowance. Overall, a pre-determined tax basis that is lower than the distribution by the sister ETF makes it possible to generate positive interest effects if the flat-rate savers’ allowance has, at any rate, been systematically exhausted.
... by the current higher interest rates
In 2023, the relevant rate of return before modification rose to 2.55%. The tax consequences will only have an effect on the first working day in 2024. Nevertheless, when interest rate levels are rising it is possible to achieve full tax parity with sister ETFs as well as with funds in general.
Currently, it is therefore no longer possible to achieve positive interest effects on a regular basis by opting for accumulating ETFs. However, nor will any disadvantages arise from retaining income either.
Result for private investors
During the 2018-2022 period, it became clear that due to the structure of the pre-determined tax basis, at least when the interest rate level is low and equity market returns are moderate to high, positive interest effects are possible by investing in accumulating securities. In this case, the only, but calculable, risk is that the flat-rate savers’ allowance cannot be exploited in the same way as for distributions. In the current environment of rising interest rates, no disadvantage is however expected when compared with distributions if the pre-determined tax basis reaches or exceeds the distribution rate.