The Tax Management Triangle (also known as the Tax Control Triangle) is the phrase that is applied when using different assets that have different forms of taxation.  We all know there are several ways to fund assets.  Deciding which assets we use, combined with whether we use before tax or after tax dollars, will determine how and when the asset is taxed.

 

The Tax Management Triangle is important because it shows that we actually need all three of these.  Watch this brief video to learn why all three are needed or keep reading below:

 

 

Tax Deferred- If we use pre-tax dollars today (similar to 401K plans), then we will pay ordinary income tax on all withdrawals.

 

Most of the time when I meet with clients, especially high income earners, the first thing that they want to discuss is how they can get some deductions.  I think that pursuing deductions is fine, however this is usually created by putting dollars into tax-qualified accounts.

 

Qualified accounts are special plans that receive “favorable” tax treatment under the tax code.  They are considered to be favorable by many people because they provide a tax deduction when the money is contributed, but every dollar that is withdrawn from the account is taxed at ordinary income rates.

 

Many people have a large percentage of their liquid net worth in these qualified accounts, which may not be wise.  We do not know what the tax rates will be in the future, so accumulating a majority of our wealth in a qualified plan may be a bit of a gamble.  This is especially true if we have enough to raise us through the first few tax brackets at retirement.

 

Another consideration for those who max out their 401k plans is that you only have access to $50,000 out of the account if you come across an even better use for the money while you are accumulating it.

 

 

 

Taxable- Post tax dollars that are put into many non-qualified accounts are taxed every year.

 

Stocks, bonds, mutual funds, CD’s, etc. can fit into this category.  Interest income from these investments will mean that a 1099 is issued and tax will be due on the interest as well as the sales proceeds.

 

It can be very difficult to accumulate wealth in an account that is taxed every year.  Many people do not realize that normally the taxes are not paid out of the account, but out of lifestyle.

 

In other words, they just have a larger tax bill than they would have if they did not receive a 1099.  The taxes that are paid could have been invested had the interest on these accounts either been delayed until later or forever.

 

 

Tax Exempt- Post tax dollars that are left to grow tax deferred and then withdrawn tax free.

 

Examples of these accounts (for retirement) are Roth IRA’s and permanent life insurance.  Permanent life insurance values must be withdrawn correctly to ensure that we don’t inadvertently create a tax bill in the future.  Make sure to see a qualified insurance advisor with a reputable firm to handle this.

 

Remember that taxes are most people’s largest expense over time.  So the way that you handle the tax management triangle is extremely important.  Also remember that someone in their thirties could very easily spend as much time in retirement as they do working.

 

Considering this, we need to think about what our needs are down the road,and what our appetite for risk will be.  There is a premium for flexibility and liquidity, especially at younger ages.

 

In my opinion the third bucket makes a lot of sense when starting out, or when one gets closer to retirement and finds themselves too heavily weighted in one of the first two buckets.  An even mix between the three buckets of money ultimately seems the most prudent, and as one approaches retirement they can be tweaked as tax rates and account values express themselves more clearly


Jay Gentry

Jay Gentry

Financial Professional

Jay Gentry has been in the financial industry for two decades and has worked with countless medical practitioners.  Jay is passionate about educating physicians and helping them create long-term financial growth.