Building wealth isn’t about what you earn, it’s what you keep. Understanding the Tax Triangle is a great start in understanding how to increase what you keep.

The Tax Triangle is a foundational concept in creating a tax-efficient retirement plan. The Tax Triangle directs you to where to save and invest to maximize your after-tax wealth.

In its simplest form, the Tax Triangle is tax diversification. Investment diversification is common knowledge, but tax diversification doesn’t get enough attention.

I’ll walk you through how to how to leverage the Tax Triangle to keep more of what you earn.

The basics of the Tax Triangle

Nothing explains the Tax Triangle than an image:

As you see the Tax Triangle is made up of 3 account types:

1. Taxable – Invested with after-tax dollars and taxed annually
2. Tax-free – Invested with after-tax dollars and tax-free when withdrawn
3. Tax-deferred – Invested with pre-tax dollars and taxed when withdrawn

You might think being 100% tax-free is best. The problem is that to get to 100% tax-free, you likely overpaid tax to get there. If we had to pick an optimal Tax Triangle, it would be close to a 30%/30%/40% split.

Having a balanced Tax Triangle creates flexibility. Flexibility empowers you to strategically manage your accounts in the most tax-efficient way.

What’s inside the Tax Triangle

We know the primary account types inside the Tax Triangle are Taxable, Tax-Free, and Tax-deferred. Within those account types you will find:

1. Taxable
   • Stocks – Tax due when dividends are paid and when capital gains are recognized
   • Mutual funds/ETFs – Tax due when dividends or interest are earned and when capital gains are recognized via sale or distribution
   • Bonds – Tax due when interest is earned
   • CD’s/Money market – Tax due when interest is earned
2. Tax-free
   • Municipal Bonds – Tax-exempt bonds may be subject to state income tax
   • Roth – This can be an IRA or employer sponsored 401(k)
   • Life Insurance – Cash Value Life Insurance which is tax free via loans or death, not tax free if the policy lapses during your life
3. Tax-deferred
   • Employer sponsored plan – 401(k), 403(b), 457, SIMPLE IRA, SEP, and more
   • Traditional IRA – Individually owned, not through an employer
   • Annuities – Withdrawals may be partially tax-free return of principal

Tax-free and Tax-deferred accounts are restricted by tax policy.

Tax policy determines how much you can contribute by account type. The contribution amount can be further impacted by income earned. Withdrawing money is restricted by age of the account owner and sometimes the age of the contribution.

The Tax Triangle and building your wealth

Throughout your career, you may not have flexibility on where you save your money. Many employers only offer tax-deferred retirement accounts. If that’s you then you will likely be heavily allocated to that account type.

Where I see the greatest Tax Triangle imbalance is with employees of ESOPs. An ESOP (Employee Stock Ownership Plan) is a tax-deferred retirement plan that gives employees an ownership interest in the company.

It’s not unusual for long-term employees to see their ESOP experience significant growth. The largest tax-deferred retirement account I have seen was $25 Million ESOP. In fact, I’ve seen a janitor who earned at most $150,000 and retired with a $10 Million tax-deferred account. Contrast that to doctors who often retire with a $3 – $4 Million tax-deferred account.

The Baby Boomer generation didn’t have a lot of flexibility to optimize their Tax Triangle. Gen X started to receive this option. Millennials will have more flexibility to optimize their Tax Triangle.   

Many employees have access to employer retirement accounts (i.e. 401(k), 403(b), etc.). Most employer retirement accounts only provide access to tax-deferred accounts.

If you have the option, the choice to Roth or Not requires running the numbers. Creating a wealth plan will direct you towards what is best.  

There are some rules of thumb if you won’t take my advice and create a wealth plan. Madfientist’s analysis points towards maximizing tax-deferred accounts for early retirees.

Other sources suggest you maximize your Roth account early in your career. This means paying taxes when taxes are cheap so you can avoid taxes later when taxes are more expensive.

No matter what you should review this annually to determine what’s best given your current facts. The Tax Bracket Manager is a free tool to understand the benefit of funding a Roth or tax-deferred account. An alternative to the Tax Bracket Manager is Holistiplan.

The Tax Triangle and Retirement

As Baby Boomers enter retirement many will have an imbalance in their Tax Triangle. This imbalance will lean heavily towards tax-deferred assets.

Employees of ESOP companies may have nearly 100% of their nest egg inside their tax-deferred account. These situations create the greatest difficulty to manage the Tax Triangle in retirement.

Retirees need at least 10% of their assets in taxable assets for effective tax planning. Without any dollars allocated to a taxable account, smart Roth Conversions become difficult.

Conventional retirement planning uses taxable accounts to fund living expenses early in retirement. This is because taxable investments provide the most control over your tax liability.

Taxable accounts pay tax as income is recognized. Dividends and interest payments are paid throughout the year. Taxable capital gains are generated only when a stock is sold, or a fund distributes capital gains.

When you sell a stock, you are selling it at fair market value. The fair market value price is what you will deposit into your spending account. Of those proceeds, you only pay tax on the capital gain portion.

Let me explain with a quick example:

• Purchased stock A for $75,000 10 years ago
• Sold stock A for $100,000 this year
• The capital gain on this sale is $25,000 (i.e. $100,000 – $75,000)

This means you could sell the stock then withdraw $100,000 and owe tax on $25,000 of it. If your capital gain tax rate is 15% then you pay $3,750 in tax. After-tax you keep $96,250.

Contrast that with a $100,000 withdrawal from a tax-deferred retirement account. Here you’ll pay the ordinary tax rate on the full withdrawal.

This means when you sell the stock then withdraw $100,000 you will owe tax on 100% of it. If your ordinary tax rate is 24% then you will pay $24,000 in tax. After-tax you keep $76,000.

Knowing these rules is important as it will help you manage your tax brackets.

You can leverage this knowledge into implementing strategic tax planning strategies.

Roth Conversions are a popular tax planning strategy. The most efficient Roth Conversion strategy requires a taxable account. This is the account that should pay the tax on the Roth Conversion.

Leverage the Tax Triangle

Now that you’re aware of the Tax Triangle, use it to your advantage. Structure your cash flow to create flexibility and keep more of what you’ve earned.

Some people can set a strategy and use it forever. Some people need to adjust their strategy year by year. The Tax Bracket Manager is a free tool to help determine where to save your dollars each year.

No matter where you fall you can control your Tax Triangle and pay less tax.