Especially in these challenging times, many things can lead to a termination of employment – perhaps you received a severance package as compensation following your termination? On the other hand, maybe you have been with your company for several years and received an anniversary bonus? In both cases, you are probably wondering what the tax implications are. We will explain everything you need to know about the one-fifth method for extraordinary income.
What is extraordinary income (außerordentliche Einkünfte)?
Extraordinary Income is a type of income that is subject to income tax (§ 2 Paragraph 1 of EStG). In most cases, these one-time payments are earned over the course of several years and paid out in one sum.
According to § 34 Paragraph 2 of the Income Tax Act (EStG), extraordinary income include:
- Capital gains (when a business or part of a business is sold)
- Reimbursement for lost or foregone income or for abandoned or unperformed activities (e.g. a severance package Abfindung after termination for operational reasons)
- User fees and compensation (including interest) for land use by the public sector, provided that it is paid for over the course of more than three years.
- Compensation for many years in service (e.g. your anniversary at the company)
In this article, we focus on the most common situation: termination of employment (Kündigungen) resulting in dismissal compensation (2nd point). But don’t worry - the application, calculation and conditions of the one-fifth method apply to all of the income mentioned above.
The only exception is that capital gains (1st point) may also be taxed at a reduced rate of 56% of the average tax rate (Steuersatz) upon application. This reduction may only be claimed by taxpayers who are at least 55 years of age and/or permanently disabled and may only be granted once in a lifetime.
Reduced Wage Tax Calculation according to the One-Fifth Method
Once upon a time, there were tax allowances (Freibeträge) for severance payments, but over the years these tax allowances became extremely strictly regulated and were abolished altogether in the end. Severance payments have not been tax free since 2006, instead, they are considered taxable wages and must be fully taxed; however, you do not have to pay social security contributions for severance packages. There is an exception: if you are voluntarily insured under statutory health insurance, health and long-term care insurance contributions are payable on parts of the severance package.
Large one-time payments will cause an increase to your taxable income which is the assessment basis for your tax rate. This increase quickly slips you into a higher tax rate, which in turn increases your tax burden. High severance packages lead to an enormous effect due to progressive taxation. For this reason, § 34 Paragraph 1 of the Income Tax Act (EStG) regulates reduced taxation of extraordinary income by means of the so-called One-Fifth Method. This is how the tax is calculated:
- First, the wage tax is determined for your taxable income without the one-time payment.
- Afterwards, one-fifth of the special payment is added to your income and the tax due on it is calculated.
- Finally, the difference between the two sums is multiplied by 5 – the result is the tax amount you are required to pay on your severance package.
Example: Mr. Müller is single and has no children. In 2020, he is dismissed due to restaurant closure after working 15 years as a salaried chef. He receives a severance package of 20,000 euros.
Step 1: After deducting income-related expenses (Werbungskosten), special expenses (Sonderausgaben), and extraordinary expenses (außergewöhnliche Belastungen), Mr. Müller is left with a taxable annual income of 30,000 euros, which is subject to 5,187 euros of income tax.
Step 2: When combined with one-fifth of the severance package (30,000 + 4,000 = 34,000 euros), a tax of 6,442 euros is due on his total income.
Step 3: The difference between the calculation with and without one-fifth of the severance package amounts to 1,225 euros. Multiplying this by 5 results in a tax of 6,275 euros, which Mr. Müller must pay on his entire severance package. The tax burden on his regular salary plus the tax on his severance package amounts to 11,462 euros.
If it weren’t for the one-fifth method, Mr. Müller would be required to pay tax on his total income of 50,000 euros, resulting in a wage tax of 12,141 euros. Therefore, his tax savings from the one-fifth method come to 679 euros.
When you have a normal “low” income and there is a significant difference between your typical salary and severance payment, the one-fifth method will yield the highest tax savings.
The higher your taxable income is, the less you can profit from the one-fifth method. For example, if your income is already subject to the top tax rate of 42% (Spitzensteuersatz), the one-fifth method doesn’t even make a difference anymore.
Prerequisites for Using the One-Fifth Method
The following conditions must be met for the one-fifth method to apply:
1. Income Aggregation
According to a 1997 ruling by the Federal Court of Finance (BFH, Bundesfinanzhof), extraordinary income may only be taxed at a reduced rate if it leads to an aggregation of income for the tax year in question. For this purpose, both your actual total annual income (including severance pay and other income earned after termination) and the income you would have earned without termination of employment are compared (you can base this on your income from the previous year). If your actual income is higher than the income you would have earned, there is an aggregation of income and the one-fifth method can be applied.
Other income that you may earn after termination may include unemployment benefits (Arbeitslosengeld), income from retirement and company pensions (Alters- und Betriebsrenten) or income from a new job. It is not the type of income that’s important, but its amount and effect on progression.
2. Receiving Payments within the Tax Assessment Period
In 2015, the Federal Court of Finance reconfirmed that extraordinary income must be paid out within the tax year for the beneficial one-fifth method to be applicable. According to § 34 Paragraph 1 of the Income Tax Act (EStG), partial payments made over different tax assessment periods prevent reduced taxation.
There is, however, a de minimis limit (Bagatellgrenze) of 10%. Although this isn’t written in the legal text, it was stipulated in a 2015 Federal Court of Finance (BHF) ruling and subsequently in a 2016 letter. If up to 10% of the main benefit is paid in the next year, it is considered minor and therefore harmless.
An exception can occur when additional benefits are granted for social welfare reasons in later assessment periods following the actual compensation. If these payments amount to less than 50% of the main benefit, the main benefit can be taxed at a reduced rate. These additional benefits can include but are not limited to supplements to unemployment benefits (Arbeitslosengeld) or retirement provisions (Altersvorsorge).
You Don’t Have to Apply for the One-Fifth Method!
It is not necessary to apply for the one-fifth method. This income is subject to the “favourable tax assessment” (Günstigerprüfung) which essentially means that your employer is legally required to apply the one-fifth method if it leads to more favourable taxation for you.
If your employer cannot determine whether you have an aggregation of income (e.g. if your income from a new job is unknown), the normal wage tax for “other compensation” (sonstige Bezüge) must be performed. You can then claim the reduced taxation as part of your tax return, as the tax office (Finanzamt) will also carry out a favourable tax assessment.
Important: If you are taxed according to the one-fifth method, you are required to file a tax return in the following year (--> mandatory tax assessment)!
The One-Fifth Method in Tax Returns
If your employer has taxed your anniversary bonus or another special compensation at a reduced rate, it will be entered on line 10 (“reduced tax compensation for many years in service and reduced tax compensation”) of your income tax statement (Lohnsteuerbescheinigung). If the special payment is taxed as other compensation (therefore not reduced), it is entered on line 19 and added to your gross salary on line 3.
The payments which are taxed at a reduced rate must be entered on line 17 of Form N (Anlage N) on your tax return. If your employer didn’t tax your income according to the one-fifth method, it must be entered on line 18.
When you file your tax return with Wundertax, you don’t have to worry about forms or lines at all! You simply need to enter the correct values during your tax interview.
The tax office will check if the one-fifth method would be beneficial for you with the help of your tax return and income tax documents.
Tax Reduction When Mutually Terminating an Employment Contract
The term “compensation for lost income” according to § 24 No. 1a of the Income Tax Act (EStG) names certain requirements in order to receive reduced taxation according to § 34 Paragraph 1 of the Income Tax Act (EStG). The taxpayer must not purposefully cause the event that leads to termination of employment and if they willingly give consent to the termination agreement, it must be due to legal or economic pressure.
An example of this can be seen in the case of an administrative employee who was refused a reduced tax on their special compensation because the tax office doubted that the employee was under pressure when agreeing to the termination of their work contract. The tax office also doubted that the employee had an aggregation of income in the tax year in question as the received pension payments following the employment were not included in their total income.
The administrative employee successfully filed a lawsuit against the tax office’s decision. Both the Münster Finance Court (Finanzgericht Münster) and the Federal Court of Finance (13/03/2018 ruling, IX R 16/17) recognised an aggregation of income in the tax assessment period as further income such as pension benefits must be included in their calculation. The courts’ statement concerning the employee being under pressure assumed that the employee did not willingly cause a termination of employment; otherwise, the employer would have had no reason to grant a severance package. By granting a severance package, the employer made it clear that they were extremely interested in terminating the employment contract. Therefore, it was not necessary to determine whether the employee was under pressure to agree to the termination.
Tip: From this example, you can see that it may be worth it to make an appeal against your tax assessment notice if the tax office refuses to tax your special compensation according to the one-fifth method.