Creating Tax Diversification Using the “Tax Triangle”

June 13th, 2022 by Jim Allen

Diversification is an important component of the financial planning process. Most often we think of it in terms of portfolio diversification, using different asset classes like stocks, bonds, cash and real estate to hopefully reduce risk of loss and help meet our financial goals. However, diversifying your investments by tax treatment or “tax diversification” is equally important since taxes can significantly erode your portfolio, retirement income, and overall wealth. At Anchor Bay Capital, keeping an eye out for tax savings opportunities is a top priority and we are always looking for ways to minimize a client’s tax bite.

There are a variety of ways to minimize taxes including:

  • Maximizing income tax deductions
  • Taking advantage of capital losses (tax loss harvesting)
  • Using tax efficient investments and using asset location strategies

These are all important tools and can be very helpful in reducing the income tax bite on a year-to-year basis. However, when looking out at the long-term picture, we can’t know what tax rates will be. What we do know is that tax rates change on average every three to four years, so it is a difficult task to calculate a client’s tax situation 10 to 20 years into the future.

When creating a financial plan, we must make assumptions about future tax rates, but we should also build in flexibility in case those assumptions are wrong. This means we need to “hedge our bets” in case taxes are higher or lower than expected in the future. One way we do this is to create tax flexibility using the Tax Triangle. The tax triangle is a strategy that uses different tax buckets to diversify by tax treatment. By having different tax categories, we have the flexibility to pull income from assets that will provide the best tax benefits at the time. This, of course, requires that we start the process of tax diversification early in the planning before the income will be needed.

The tax triangle looks to use investments that are held in various tax “buckets” which generally fall into three categories:

  • Currently taxable
  • Tax-deferred
  • Tax-free (or tax favored)

The concept is to create a diversified portfolio using all three tax categories and have the flexibility to pull from the buckets that will minimize taxation the most at the time.

Currently Taxable: Examples of currently taxable assets would be stocks, bonds and mutual funds or ETFs held in a brokerage account or a living trust, rental real estate, and money market accounts and CDs. Income from the interest, dividends, or capital gains from these investments are reported on the current year’s tax return but any growth isn’t taxed until the asset is sold. With currently taxable investments, there are opportunities to take advantage of potential favorable capital gains rates or maybe tax losses. There are also income tax benefits at death in the form of a stepped-up cost basis.

Tax Deferred: Examples of tax-deferred accounts include 401(k)s, IRAs, other types of retirement plans and non-qualified deferred annuities. Some, but not all, of these types of plans allow for a tax deduction up front and/or tax-deferred growth. The trade-off for the up-front tax deduction is ordinary (not capital gains) taxation when the funds are distributed and a 10% penalty tax for certain distributions prior to age 59 ½. Assets in these types of plans are also taxed to your beneficiaries at death. The tax deferred bucket is typically the largest bucket for most clients.

Tax-Free: The most common type of tax-free investments are municipal bonds, health savings accounts (HSAs) and Roth IRAs & 401(k)s. However, other sources of tax-free income include cash value life insurance[i] and accessing home equity using a reverse mortgage or line of credit. With the tax-free / tax favored bucket, contributions to the accounts are made with after tax dollars (except for HSAs) which is one of the primary trade-offs for tax-free distributions. There can be other trade-offs as well, including reduced rates of return for municipal bonds and restrictions on contributions and distributions for Roth IRAs.

The concept of the tax triangle is to have funds in all three buckets, and then use them in the most tax effective manner on a year-by-year basis. With proper planning, we can create a tax diversified portfolio using qualified plans and IRAs, Roth IRAs, taxable accounts and other sources like HSAs, annuities and life insurance. But, what we often see is too much concentration in one bucket (usually the tax deferred) and we need to create a diversified portfolio using the tax triangle.

Optimizing your Tax Triangle

Through a process of annual planning and tax projections, we can develop a plan to maximize your tax diversification strategy. This could mean looking at partial Roth IRA conversions each year, doing “back door” Roth conversions, contributing to an HSA (if eligible), making Roth 401(k) contributions instead of regular 401(k) salary deferrals or contributing less into the retirement plan and instead putting funds into a taxable account. Maximizing your personal tax triangle is very dependent on your individual tax and cash flow situation, and it isn’t static- it changes year by year.

If you would like a complementary tax analysis and portfolio review, please contact our office to schedule your consultation.

Jim Allen, CFP, ChFC, EA, CDFA is President and Chief Financial Planner at Anchor Bay Capital. In addition to his 35+ years of financial planning experience and his professional credentials, he holds a master’s degree in Financial Planning and is a former instructor in the CFP program at the University of California Irvine. He is also the co-author of the book “The Tools & Techniques of Charitable Planning.” Jim can be reached at [email protected]