What is the most effective way to save taxes?
The most effective way for employed individuals to save on taxes is to purchase additional benefits into their pension fund. It sounds simple, but there are many things to consider.
Pension funds distinguish between defined benefit and defined contribution plans. Defined contribution means that benefits are calculated based on accumulated personal retirement savings. Defined benefit plans calculate benefits as a percentage of insured income. Most pension funds in Switzerland operate the defined contribution plan.
Purchase into the pension fund
In a defined contribution plan, insured persons can voluntarily reduce or close their contribution gap by purchasing additional benefits into the pension fund (if the pension fund regulations allow it). Contribution gaps (also called insurance gaps) typically arise due to salary increases, but can also have other reasons, such as career breaks, increased workloads, divorce, or moving to Switzerland after the age of 25.
By purchasing additional benefits into the pension fund, the insured person can increase their savings to the maximum level they would have had they received the same (last) salary since age 25. Therefore, this purchase is sometimes referred to as "buying in the maximum retirement benefit" or "buying in missing contribution years."
The advantage: Purchases into the pension fund are fully tax-deductible and increase the savings balance and thus also the future benefits of the pension fund.
What else needs to be considered?
But before making a purchase, there are a few important points to consider:
The majority of pension funds (85%) in Switzerland insure more than the minimum required by law. Such funds are called "comprehensive" pension funds and thus have both mandatory and supplementary capital. A purchase amount in a comprehensive pension fund is in most cases attributed to the supplementary capital, with far-reaching consequences.
According to the BVG, only the interest on mandatory retirement savings is regulated by law (a minimum interest rate set by the Federal Council). Extra-mandatory savings are not subject to interest. The conversion rate is also only legally fixed for the mandatory portion. For the extra-mandatory portion, the pension fund sets the conversion rate independently. In fact, this rate is often significantly lower in the extra-mandatory portion than in the mandatory portion.
This is important because many pension funds could find themselves in a difficult situation in the current low-interest rate environment. Paying no interest, or very low interest, on excess savings for a certain period is a popular restructuring measure.
Therefore, it is essential to familiarize yourself with the pension fund's financial situation and detailed regulations before purchasing benefits. These include, among other things, the current interest rate on savings, the coverage ratio, the technical interest rate, and the ratio of pensioners to active members.
Legal purchasing restrictions
Once these fundamental points have been clarified, the following purchasing restrictions must be reviewed:
- An advance for home ownership must be repaid before a purchase can be made.
- Persons who have moved to Switzerland from abroad and have never been members of a Swiss pension scheme may purchase up to 20% of their insured salary in the first five years.
- Balances on vested benefits accounts or policies must be deducted from the maximum purchase amount.
- Self-employed persons with a balance in the large Pillar 3a must deduct this balance from the maximum purchase amount.
- If purchases are made in lump sum within the next three years, the purchase will not be retroactively tax-deductible (post-tax procedure). This is a legislative measure to prevent tax evasion.
A balance in the small Pillar 3a has no influence on the purchase amount.
Last but not least, it should be noted that a pension fund purchase is generally a long-term investment. You must be able to spare this additional amount. Therefore, it is advisable, also due to tax progression, to make purchases in the same year in which, for example, a large bonus or gratuity was paid out. Careful planning is essential.
Pension funds in Switzerland enjoy relatively considerable leeway in structuring their benefits and organization. In particular, each pension fund has its own regulations, which, among other things, govern purchases. Therefore, the individual situation should always be reviewed before making a purchase.