Personal Finance 101 – The Tax Management Triangle

Don’t you wish that you had a crystal ball to know what the tax rates will be 20 years from now?   In 1970, the top tax marginal tax rate was at 70%.   In 1980, the top marginal tax rate was still at 70%.   In 1990, the top marginal tax rate hit a historical low of 28%.   In 2000, that top marginal tax rate had moved back up to 39.6%.   Just one year ago in 2010, the top marginal tax rate settled at 35%. (source: taxfoundation.org)  With all the uncertainty going on with our debt and taxes, how can you best plan your finances for the certainty of uncertainty when it comes to income taxes?

Over the years, we’ve adopted a tax triangle methodology around taxes and investing.  This allows an individual investor or business owner to think about where they place their investments and tax strategy upon the accumulation and distribution phase.  Here are the three sides to the triangle.

  1. Money invested pre-tax that will be taxed as ordinary income down the road Most of you think of this part of the triangle as your 401(k) or 403(b) plan that you invest in through your paycheck at work.   The idea of putting money into this part of the triangle is that it reduces your current tax liability today, and hopefully you will be in a lower tax-bracket when you distribute money down the road.   While the assets are growing, they will increase on a tax-deferred basis so you don’t see annual taxation on your tax return.   While it does stand to reason that you will have less total income per year when you retire, but imagine you made this decision in 1990 and were now distributing this money at the highest rate today.  In retrospect it would not have looked like the best decision.   This is why putting all of your eggs in this basket alone will not make sense, but it is important to build up money in this part of the triangle in case this is the cheapest distribution source when you retire.   You also need to consider that for the large part these assets are tied up until retirement years, as there can be significant taxation and penalties for withdrawing early.
  2. Money invested after-tax that will be taxed along the way (and possibly at the time you sell) Once you have paid income tax on earned income, you may invest those monies in vehicles such as money market accounts, CD’s, stocks, bonds, mutual funds, etc.   These investments can generate interest and dividends every year that will add to your overall taxable income.   This can create current taxation on those assets which could be as high as your marginal income tax rate which is important to review in both the accumulation and distribution phase.    The main issue to keep in mind around the stock/mutual fund type investments is in the arena of capital gains.   Capital gain rates historically can be very tricky to look at, but they are at an all time low today around 15% for the upper income tax bracket taxpayers.   They were in the 30% range roughly 20 years, and even higher before that.  In this tax bucket, you need to pay close attention when you sell these assets to ensure you pay the least amount of taxation as you own the asset. 2013 will bring us another change to this part of the triangle, so pay attention closely to your trigger point over the next few years.
  3. Money invested after-tax that you won’t be taxed again in the future In this asset class, the most recognized vehicle is the Roth IRA.  Although this got introduced in 1997, it has really become popular over the past several years including the Roth 401(k) that has been added to most plans.    The reason it is important to add dollars into this part of the tax triangle is that once these assets are taxed, they will never be taxed again as long as they are distributed correctly down the road.

Imagine it is 20 years down the road and you are at the kitchen sink called retirement.   The choice at retirement is to figure out which faucet to turn on with your retirement dollars so you can get income with the least amount of taxation.  The only way that decision can be made is to accumulate money in different areas during your working income years with the appropriate balance that will afford you the luxury to have enough money in the right parts of the triangle so you can pay the least income tax down the road.   This tax triangle is the cornerstone of good tax management . . . get your triangle going today! Add A Comment

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Ted Jenkin, CFP®, AAMS®, AWMA®, CRPC®, CMFC®, CRPS®

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About the author  ⁄ Ted Jenkin @ Your Smart Money Moves

Ted Jenkin @ Your Smart Money Moves

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2 Comments

  • EL
    March 11, 2015

    This is a good strategy for the average investor as it will help diversify taxes and assets for the future. Now people can invest stocks/Bonds/ETFs in after tax brokerage or Roth or traditional IRA’s. When the options are readily available its important to understand how to invest properly. Do you have a more in depth tax triangle resource?

  • Ted Jenkin @ Your Smart Money Moves
    March 13, 2015

    Yes- please call my business partner Kile Lewis at 770-777-0427 and he can walk you through it

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