Index Fund Investing, Israel Edition – Part IV: Tax Considerations

This post is part of a series: How do I start investing in index funds? Israel edition. Read the posts in order here:

Before making Aliya, I went to a lecture about arranging finances in Israel. I felt a bit silly, as I was the only one below the age of 40 at the talk. However, I don’t regret going, as the accountant who gave the talk delivered a maxim I still haven’t forgotten: “don’t let the tax tail wag the dog”. In other words: don’t let tax implications be the decisive factor in how you conduct your affairs. Instead, allow them only to modify slightly how you structure things within the confines of your existing decisions. With that in mind, let’s proceed.

I’m not an accountant so this will not be comprehensive. There won’t be any secret tricks here, just a basic overview of some widely known tax rules and tax structures. I will categorically not be addressing tax considerations that apply to US citizens: note that these are significant and can completely change the tax situation.

Capital Gains Tax and Dividends Tax

Starting at the most basic level, if you just make a regular investment in Israel in stocks & shares with no special tax status, you will be charged by Israel’s Tax Authority 25% tax on real earnings from the investment. For dividends paid out, this is simply 25% of what is paid out. For growth in the value of the holdings (capital gains), you are charged 25% on the real earnings – i.e. the amount your holding went up beyond inflation. This is only paid at the point when you realise the earnings e.g. by selling the units. Until then, gains or losses are still in flux and are referred to as unrealised.

A few complications already: while the above is true for stocks and shares, other asset classes such as bonds and REITs are taxed at different rates. Moreover, the bit about the 25% tax on “real earnings” is only true for shekel-denominated funds. For funds denominated in other currencies, you don’t get to deduct inflation: neither in the shekel nor in the other currency. This is on the spurious basis that inflation is already encapsulated in the fluctuations of currency exchange rates, which dishonestly disregards the existence of inflation in other currencies too*. Anyway, that’s the reality.

Withholding tax and estate tax

When you invest in US stocks, they withhold 15-30% of the dividends as tax which goes to the IRS**. Another issue with US stocks is that if you’re a non-resident alien they will take estate tax (inheritance tax) from an absurdly low threshold of $60,000. For these reasons, I try to avoid US-domiciled funds.

Ten year tax exemption for Olim

Olim and some other statuses get you a 10-year exemption from reporting and paying tax on foreign income. This gets tricky to define: if I buy an Israeli mutual fund but it invests in US stocks, is this foreign income? So I queried the Tax Authority, and my understanding is: income from foreign-domiciled funds is exempt; income from domestic funds is not exempt. Thus profits from a Vanguard fund domiciled in Ireland that tracks the FTSE 100 index are tax-exempt (for the 10-year period), while profits from a Migdal fund domiciled in Israel that tracks the FTSE 100 is not tax-exempt.

This is a very comprehensive exemption, in my opinion the best of all the options mentioned in this article, and therefore worth exploiting if relevant. The problem is ensuring that you really are exempt and choosing a broker that will respect this. You could try to persuade an Israeli broker that you are legally exempt, and not to deduct tax at source. But then you run the risk of the Tax Authority claiming that these profits weren’t exempt, because you invested through an Israeli broker and so arguably the earnings were not entirely foreign. You could invest the money in a foreign brokerage but then you face problems with shifting around potentially large sums of money, and executing currency exchange. I have no simple solution; the best approach needs to be decided on an individual basis.

Major tax structures

There are three general tax structures in Israel which allow you to avoid paying taxes on earnings from investments. These are: Keren Hishtalmut, Pension Funds, and Kupat Gemel LeHashka’a. See here for brief definitions of each and a nice table comparing the tax benefits. Obviously, the outcome of an investment will be larger if the investment is tax exempt, so we want to avoid taxes all other things being equal. However, these tax structures often have limitations and drawbacks. Here I’m going to discuss the use of these tax structures through the lens of deciding how to structure an investment.

Nihul Ishi (self-management, aka IRA) vs managed

In the brokerage article, in the innocent days before tax came along and wrecked everything, I mentioned that there were two tracks: what I called a “two-layered” approach, where you choose a brokerage and then choose investments (such as index funds) through that brokerage; and a “one-layered approach” where you give your money straight to an institutional investor and they manage your investment for you, typically with an active management policy. You probably decided then which approach you wanted to adopt (my preference is the first), but unfortunately the tax rules are not uniform and distort this decision.

Many of these tax structures are simply not available in the two-layered approach, meaning you’re forced to entrust your money in the hands of an investment board, a thought repellent to anyone who has noticed that active funds tend to have worse performance than passive funds. In these cases, you can only choose a generic Maslul (track with broad investment policy) such as “shares” or “bonds” or “general”. Even the ones that do offer a two-layered approach, aka Nihul Ishi (self-management) aka IRA, often have high minima for opening an account and charge unreasonable fees. This is a major drawback of the tax structures in Israel.

Annuity requirement

Pension Funds and Kupot Gemel LeHashka’a require you to buy an annuity with your accumulated retirement pot. Lump sum withdrawals are possible, once you’ve reached a minimum required annuity, but this is more complicated than needed. An annuity is a form of insurance, which won’t be suitable for everyone (you may think you can get a better return than the annuity offers; or you may want to pass on some of the money to your children straight away; or any number of reasons). If you invest your money ordinarily, with no tax structure, you can choose to buy an annuity or not to buy an annuity with any proportion of the money. The tax rules here are introducing another distortion wherein the decision is made for you.

Extra fees eating away at returns

When you look at the annual fees (Dme Nihul) of one of these tax structures, they don’t sound too bad: usually somewhere between 0.1% and 0.8% of your accumulated balance. If you didn’t know better, you’d say, “with an index fund, I’d have e.g. 0.25% annual fees, as well as brokerage fees, so the tax structure is cheaper”. But hidden deep inside the tax structure’s annual report is another, less transparent fee – Hotsa’ot Nihul Hashka’ot – which is actually the equivalent fee to the index fund’s annual fee. The only way to find out how much this comes to is by finding the figure on your annual report at the end of the year. In my own Pension Fund it comes out to about 0.2-0.3%, comparable to the management fees of an index fund. In light of this, the quoted Dme Nihul should technically be compared to the fees you would pay on a brokerage account.

With Pension Funds, there are typically also one-time fees taken off the deposit, between 1-6%. In my opinion, anything below 1% is reasonable (likely not drastically different from the currency exchange fees and trading costs you’d pay when buying funds through a brokerage); anything above this is outrageous. Another “fee” to bear in mind is the actuarial adjustment: on Karnot Pensia specifically. In theory, this is supposed to average out to zero: it can some years be positive and others be negative, but adds an element of risk that simply doesn’t exist in other tax structures and normal investment accounts.

Keren Hishtalmut – the crown jewel

Advantages:

  • No tax on your investment earnings
  • Fund becomes fully liquid and available to you 6 years after opening it, but continues to be tax-free if you leave the money in it
  • Additional tax exemptions on deposits (for employees, the employer contributions are exempt from income tax and NI; for self-employed, contributions are tax-deductible)
  • Comes in self-management (IRA) format allowing you to select your own funds to invest in (with mild limitations that don’t affect passive investors)

Disadvantages:

  • Only available to people in work, and only available if the employer offers it. You can’t just choose to open one up. On months where you aren’t working, you can’t contribute at all.
  • Fairly limited in size: maximum contributions of 18,854 ₪per year
  • Self-management (IRA) format not widely available, usually has a high minimum to open

The Keren Hishtalmut has the best conditions of all the tax structures, and is probably a no-brainer provided you don’t pay US tax. If your employer doesn’t offer it, you should implore them to restructure your salary so that the salary cost to them remains the same but with a Keren Hishtalmut (this will even increase your overall income, as you’ll be making about 7% of the salary non-taxable). Once it grows big enough, you might decide it’s worth moving to a self-management fund and doing index fund investments.

Pension Funds – compulsory, complicated and highly individual

Pension Funds is the term I’m using as a broad translation for three different fund structures, which have basically the same tax rules: Keren Pensia, Bituah Menahalim and Kupat Gemel. As pension is compulsory, and there is little flexibility in how much you contribute to them, the question here is less whether it’s worth having one and more what to do with the ones you have.

Advantages:

  • No tax on your investment earnings
  • Tax exemptions on deposits (tax incentives on employee contributions, and employer contributions are exempt from income tax and NI)
  • The Kupat Gemel comes in self-management (IRA) format allowing you to select your own funds to invest in (with mild limitations that don’t affect passive investors)
  • The Keren Pensia allows you access (up to 30% of your holdings) to special government bonds (Agaẖ Meyo’adot) with a fixed rate of 4.86%.

Disadvantages:

  • Only available at retirement age
  • Taxed as income upon withdrawal
  • The most common structure (Keren Pensia) exposes you to actuarial risk and doesn’t allow self-management format

Kupat Gemel LeHashka’a – very limiting

Not to be confused with a Kupat Gemel, the Kupat Gemel LeHashka’a is entirely optional, and you put money in it from your take-home pay or from savings. The disadvantages of this tax structure are so limiting that in my opinion in many cases it’s better to just make a regular, tax-liable investment.

Advantages:

  • No tax on your investment earnings IF you don’t withdraw until age 60 AND withdraw as an annuity
  • Changing investment tracks / investment manager is not considered an actualisation (tax event), only exiting the Kupat Gemel LeHashka’a is
  • High ceiling on contributions (70,000 shekels per year); available regardless of employment situation

Disadvantages:

  • No self-management (IRA) format
  • To take full advantage of the tax exemption must wait until age 60, and must withdraw as an annuity, not lump-sum

Political note: needless complications creating distortions and waste

I usually take an attitude of focusing on things we have control over, and not getting too worked up on things we don’t. Ultimately, the rules that govern these tax structures are out of our control; we can only control how we allocate our money within the framework of these rules. But I can’t resist the opportunity to note something I feel strongly about: the rules of these tax structures, in particular pensions, are far too complicated, and the same effects could be achieved even with much simpler rules. Indeed, many other countries successfully encourage saving for pensions with rules simple enough to understand without having to have a consultation with a pensions agent. Even if you accept that it’s the government’s role to encourage long-term savings, this surely does not necessitate the existence of three different types of tax structures, with entirely different rules, and sub-structures within them.

Conclusion

I hope the above, together with the other articles in this series, have given you decent exposure to the steps you’ll need to take to invest in the stock market from Israel. Don’t be too daunted by the complications heaped on by the institutions and governments. The important thing is to get started and not miss out on the huge long term returns the stock market has to offer.


*In case this is not clear, consider two 10-year 10,000₪ investments bought and sold, by coincidence, on days when the shekel-dollar exchange rate was exactly the same (all things being equal, in this scenario, the shekel and dollar endured the same inflation over the 10 years). If you bought a shekel-denominated investment, you pay tax of 25% * (final sum – [10,000 ₪* inflation over 10 years]). If you bought a dollar-denominated investment, you have to pay 25% * (final sum – 10,000₪). Not fair.

**I believe you can deduct this from the tax that is due to the Israel Tax Authority, but (a) that’s effort, (b) if my tax is going anywhere I’d prefer it to go to Israel; (c) if I’d otherwise be exempt from tax this is just money down the drain.

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