What taxes are you going to pay on your investments and the importance of delaying them

What taxes are you going to pay on your investments and the importance of delaying them

Home > Investment > How to invest > What taxes are you going to pay on your investments and the importance of delaying them

There are few things that are 100% certain in an investment, but taxes are one of these, as are commissions. With a few exceptions, there comes a time when you have to pay taxes on the profit you make and it is important that you know how much, how and when.

Why is it important to know the taxes on your investments?

The average annual return of the Ibex 35 with dividends is around 8% (7.94%), a very attractive percentage which, however, does not take into account the reality of what will end up in your current account if you were to invest in the Spanish stock market.

That 8% is the nominal return, not the real one. In other words, it does not include the expenses inherent to the investment, such as the commissions you have to pay, which are absolutely variable. These expenses will depend on the product through which you invest, the broker, bank or platform you use and your own transactions.

For example, imagine that you invest 10,000 euros in the Ibex 35. With a profitability of 8% you should receive 800 euros in your account. However, as your trading has costs of 1.5%, that return is reduced to 6.5% and in reality you will only have earned 650 euros.

This nominal return also does not include a cost that everyone has to pay:  tax. Your investments are taxed on your income tax return and the percentage of tax you pay will determine the difference between the nominal and real return on your investments.

Returning to the previous example, you will have to subtract taxes from the 650 euros of profit. As a general rule, the tax office initially applies 19% to this capital in anticipation of what you will have to pay later (the IRPF, or personal income tax, withholdings that also apply to most financial products). As a result, you will only receive 526.50 euros.

Finally, to gauge the real return on an investment you should also take into account the effect of inflation, which is the value your money loses due to general price and cost-of-living increases. Inflation is one of the reasons why simply saving is not enough to secure your future.

A quick review of how your investments are taxed

How much tax do you pay on your investments in your tax return? The answer depends on the specific product you invest in.

Apart from pension plans, insured pension plans and a few other exceptions, most of your investments will be taxed as what is known as savings income; this is differentiated from your salary and other income that is added to the general base.

The tax office divides investments into two main groups:

  • Capital gains and losses.
  • Income from movable capital.

Very briefly, each group is first taxed separately and then everything is added together to calculate how much you have to pay.

How capital gains and losses work

This group includes most investments. These are gains and losses from investing in stocks, mutual funds, ETFs, index funds, warrants, and CFDs, in addition to selling your home and investing in cryptocurrencies.

There are four golden rules in the taxation of capital gains and losses:

  • You pay when you sell the good or asset. If your fund or your shares are rising, but you keep them in your portfolio, you do not pay anything unless you receive a dividend or other type of payment (moreover, this would be income from movable capital). You only pay taxes when you sell the asset, when you obtain the profit, or gain.
  • You pay for the gains or losses, which are normally calculated based on the difference between the purchase value and the sale value. In other words, you have to subtract the price at which you acquired the asset from the price at which you sell it.
  • They work according to the FIFO rule of First In, First Out. This means that the first shares or units of the fund you bought are sold first, which is important if you invest periodically.
  • Losses offset gains and vice versa. This point is key to planning your taxes and tax payments. You can subtract the losses from the profits you have made, first for each product individually and then between them.

For example, if you have earned 2,500 euros with your shares, but you have lost 1,500 euros in cryptocurrencies, you can reduce your gains by subtracting your losses. This way, for the tax authorities, it will be as if your capital gains were only 1,000 euros.

What if you have lost money over the year? You will be able to compensate a portion of this with income from movable capital (you will understand it all better in a moment).

How does income from movable capital work?

The income from movable capital is the money you receive from the dividends of the shares or funds in which you invest, current and interest-bearing accounts, treasury bonds and debt in general, loans and life insurance.

One of the differences compared to capital gains and losses is that with this type of product you normally do not have to calculate what the gain is, because it is already assigned. Think of a deposit, where you normally know in advance what you are going to earn, or dividends, where you do not have to calculate anything, you earn whatever you are paid.

This income from movable capital is also offset against itself, just like gains and losses. The total is what is then taken into account when calculating how much tax you will have to pay.

Add it all up and pay tax

After calculating your capital gains and losses on the one hand and your income from movable capital on the other, it is time to put the two together, in other words, to add the two parts that make up your savings income.

If the first part is in negative (you accumulate capital losses), you will be able to subtract up to 25% of the income from movable capital from those losses and vice versa. You cannot allocate the rest of the losses in that income tax year, but you will be able to do so in the following four years. In other words, if you lost money in 2021, you will be able to use it to offset gains in 2022, 2023, 2024 and 2025.

The sum of the two sections is what you will pay taxes on; this is your savings tax base. A scale with four value brackets is applied to that amount.

BracketTaxes to pay
Up to 6,000 €19.00%
Between 6,000.01 € and 50,000 €21.00%
Between 50,000.01 € and 200,000 €23.00%
More than 200,000.01 €26.00%

These brackets are applied progressively, meaning if you have earned 10,000 euros through an investment, you will not pay 21% on the full value, only on 4,000 euros (the difference between 10,000 and the 6,000 euros in the first bracket).

The most important thing you can do: delay paying taxes

There are many ways to save on tax and optimize your investment, such as taking advantage of the possibility of offsetting losses and capital gains, as we have seen in the previous point and as illustrated in the graph from the tax office. However, the most powerful and simple way to do this is not to pay taxes until the end.

In other words, delay the payment of taxes as much as possible. This is what is known as tax deferral and is the equivalent of compound interest in tax terms. The difference is that you can always apply compound interest, but you can only defer the tax on certain financial products such as investment funds, PIAS, pension plans, Unit Linked and insured pension plans.

These products allow you to move your investment without having to pay tax on it. For example, you can change PIAS without paying tax on the profits you accumulate and the same with a mutual fund or a pension plan.

This way you avoid paying between 19% and 26% in tax every time you want to make a change in your portfolio to adapt it to your personal situation or that of the market (remember that you will not invest in the same way at every stage of your life). For example, you can switch from a variable fund to a fixed income fund without paying tax.

What about shares? You can also delay paying taxes by following strategies such as Buy & Hold, which involves not selling the shares. As soon as you liquidate a holding and sell your shares, you will be taxed on the gains you accumulate. In other words, each change in the composition of your portfolio will mean paying taxes.

How does tax deferral impact your investments? The best way to understand the importance of tax deferral is with a specific example.

Imagine two people who invest 10,000 euros and are able to achieve an annual return of 8.5%, in line with the historical return of the American S&P 500 index, without deducting expenses and commissions.

The only difference between these two investors is that the former pays taxes each year on their earnings and the latter does not. In other words, the former does not have tax-deferred investments and the latter does. What is the difference over time? This is how their investments would evolve:

No tax deferral
Accumulated capitalGross returnTaxesReal return (after taxes)
Year 110,000.00 €1,000.00 €190.00 €810.00 €
Year 210,810.00 €1,081.00 €205.39 €875.61 €
Year 311,685.61 €1,168.56 €222.03 €946.53 €
Year 512,632.14 €1,263.21 €240.01 €1,023.20 €
Year 1018,646.85 €1,864.69 €354.29 €1,510.40 €
Year 1527,525.42 €2,752.54 €522.98 €2,229.56 €
Year 2035,433.86 €3,011.88 €572.26 €2,439.62 €
Year 2549,431.33 €4,201.66 €798.32 €3,403.35 €
TOTAL52,834.67 €52,882.31 €10,047.64 €42,834.67 €

 

With tax deferral
Accumulated capitalGross returnTaxesReal return (after taxes)
Year 110,000.00 €1,000.00 €- €1,000.00 €
Year 211,000.00 €1,100.00 €- €1,100.00 €
Year 312,100.00 €1,210.00 €- €1,210.00 €
Year 513,310.00 €1,331.00 €- €1,331.00 €
Year 1021,435.89 €2,143.59 €- €2,143.59 €
Year 1534,522.71 €3,452.27 €- €3,452.27 €
Year 2047,115.63 €4,004.83 €- €4,004.83 €
Year 2570,845.74 €6,021.89 €- €6,021.89 €
TOTAL76,867.62 €66,867.62 €14,259.55 €52,608.07 €

As you can see, the tax deferral helps you to accumulate more money at the end, and even more real return. And you will pay more tax in total on your investment. In addition, it also shows the progression of the savings tables. Although you earn 66,867 euros, you do not pay 23% on that amount, only on the portion over 50,000 euros. For the rest you will pay lower percentages. Hence, the final tax result is 14,259 euros and not 15,379.5 euros.

In any case, this example illustrates the magic of delaying taxes on your investments, something you can do just by choosing the right investment products.