The Yield Shield: Taxes

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I thought I was done talking about this, but due to the high level of interest in this series, I’m going to do one more article on this, as well as create a series that you can access from the menu bar. Just hover over “Series” and you’ll see a link to the Yield Shield articles.

So to recap, we’ve covered the Four Pillars of the Yield Shield, which are:

  1. Preferred Shares
  2. Real Estate Investment Trusts
  3. Corporate/High Yield Bonds
  4. High-Dividend Stocks

And we also talked about how to put these pillars together to boost the yield of your portfolio and how this can be used to reduce the amount of Cash Cushion you need to keep outside to hedge against sequence of return risk.

Today I’d like to talk about the tax implications of building your Yield Shield.

Generally, you can get all the benefits of the Yield Shield without paying a single dollar of taxes, but it does require a bit of prep work and planning. This prep work can be divided up into two time periods: Before Retiring and After Retiring.

Before Retiring

A question I got multiple times from the last post was how you’re supposed to build your Yield Shield without incurring massive capital gains taxes? In the comments, regular reader AngryRetailBanker responded:

Instead of selling anything out of your existing portfolio, why don’t you just spend your last 1-2 working years allocating new capital towards your Yield Shield investments?

ARB–Angry Retail Banker

Right on. The correct time be building your Yield Shield is the last few years right before you retire. This way, you don’t have to worry about realizing any capital gains by selling something you already own, you simply redirect the cash you’re deploying into your portfolio into Yield Shield assets.

That being said, if you already retired and still want to create a Yield Shield, are you screwed? Not exactly. There are a few ways you can still build it without incurring a massive tax bill, and it all depends on what your own personal tax situation.

Option 1: Harvest Capital Loss

If you’re “lucky” enough to be sitting on a capital loss rather than a capital gain (not sure if that’s the right definition of luck, but whatever), you can just sell your assets as normal and harvest the loss. You’ll be buying unrelated assets so you don’t have to worry about the 30-day wash sale rule, and you’ll be able to keep those capital losses to offset future capital gains.

Option 2: Sell your most recently acquired units using the LIFO method

This one’s uniquely American. In Canada, the cost basis of our stock units are calculated as an average of all the units you own, but in the US, each individual stock unit has its own cost basis and you can actually pick which one you want to sell. By default, the IRS assumes you sell your stocks in a FIFO manner. The engineers in the audience will immediately know what that means, but for everyone else this stands for First-In-First-Out.

If you were to buy 100 units of AAPL a year ago, then 100 units of AAPL today, then decide to sell 100 units of AAPL tomorrow, the IRS would assume you are selling the first 100 units you bought a year ago. They would calculated your capital gains based on the price of that first 100 units at the time you bought it, and you’d pay capital gains tax at the long-term capital gains tax rate.

However, you can choose to sell your units in a LIFO, or Last-In-First-Out manner. You have to arrange this with your broker to make this election at the time of sale, but if you did it this way then the sale of the 100 units would instead come from the 100 units you just bought. In this method, the capital gains would be taxed at short-term tax rates (which are like regular income), but if those units aren’t sitting on a capital gain, you could do it tax-free. You might even be able to do it at a capital loss. Check with your broker to figure out how to make this election, and see what the tax implications are for each of your ETF units carefully before doing this.

Option 3: Gradually build up your Yield Shield using the 0% LT Capital Gains Tax Bracket

In the US, a couple filing jointly can realize up to $77k of Long-Term capital gains each year tax-free. Remember that $77k is realized capital gains, not the amount of ETFs you’re selling. Depending on the cost basis of each ETF unit in your portfolio, you may be able to sell hundreds of thousands of units before hitting this $77k capital gains limit.

It may take a few years, but if you carefully manage your taxes, you should be able to still build your Yield Shield without paying any tax.

And remember, you can also do a combination of all 3 options. Immediately sell units that are sitting on a capital loss, then find some ST capital gains you can sell using a LIFO sale method, and then realize the rest of your $77k LT capital gains tax-free window in a FIFO sale. That may be enough to do everything in one shot.

As always, check with a tax professional before implementing any of these strategies. I don’t know your personal tax situation.

After Retirement

After retirement, managing your Yield Shield is super simple: Just make sure you keep your Yield Shield assets in the right accounts and you’re good to go.

Preferred Shares pay their yield as Qualified Dividends, so keep these in your Regular Investment Accounts.

REITs pay their yield as normal income, so keep these in your RRSP/401(k).

Corporate/High Yield Bonds pay their yield as interest income, so keep these in your RRSP/401(k).

High-Dividend Stocks pay their yield as Qualified Dividends, so keep these in your Regular Investment Accounts.

That’s it! If you do this, the yield from your Yield Shield will pay out completely tax-free forever, and every December you can just go in, harvest all this spare cash, and use it to fund your next year’s living expenses.

Here’s exactly how I did my withdrawals at the start of this year, if you’re interested.

And that’s it! Questions? Comments? Let’s hear it below. And again, I’ve linked these Yield Shield articles into a series you can now access through the menu bar at the top for future reference.

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20 thoughts on “The Yield Shield: Taxes”

  1. Good stuff Wanderer. The only thing I might add to this is you might want to begin building yield earlier if your income is unstable.

    Some industries are like that. Feast and Famine. The dividend yield is a great way to “smooth” out the earnings.

    Certainly worked well for me.

  2. Wait what? I can realize $77 grand a year in LT gains and not pay taxes? how does that work? I sold 5 grand last year and it was taxes at 15% so…what am I missing here?

    1. Sure, if you put REITs and corporate bonds in your TFSA, it will also be tax free. I like to use my TFSAs for equities, but if you have extra room those are fine to be in there too.

  3. My brother in law taught me a important Canadian tax withdrawal tip. If you withdraw from your RRSP in 5000 incraments you only get charged 10% withholding tax. You still owe the same in taxes but just a little more on the front end.

  4. Don’t forget that in several provinces and territories in Canada, if your total income is low enough, you actually pay a NEGATIVE tax rate on Canadian dividends. (Yes, the government gives you a refund when you earn money in this case!)

    This is because of the interaction between the dividend gross up and the dividend tax credit.

    I’m not sure of all the details exactly, but the max income to take advantage of fully tax-free dividends in non-registered (i.e. taxable) accounts is something around $50k. I can’t remember if that’s per person or per family.

    I’m no tax expert, but hopefully this tips off a few readers to head out and do some additional digging on the subject 🙂

    1. That always gets me. Correct, at certain points of the dividend-income-tax-burden curve, you can actually get a negative tax rate. Add in GST/HST refunds and it’s possible to MAKE money at tax time for some early retirees.

  5. I really think that dividend investing give you the piece of mind when the market tanks. You’ll still receive income on a regular basis and if you’re FIREd this is what matters. You don’t have to sell or even bother to look at how the market is doing.
    If you index, you’ll be so worried and inclined to get out and time the market that I feel that is way more dangerous than dividend investing. Who agrees with me?

    1. Fellow dividend investor here.

      I don’t think index investing is more “dangerous” in any way, but I don’t think it allows you to seek out and capture value either.

      Buying individual dividend stocks is like haggling with the market. The market may be st record highs, but you can find plenty of great bargains in there. Buying the market itself is essentially being told “This is the price. Take it or leave it.”

      Both are great ways to invest, but that’s the weakness I see in index investing.

      ARB–Angry Retail Banker

  6. Great article and thanks for the shout out!

    I didn’t know about the FIFO/LIFO rule. I always thought they averaged your cost basis. My brokerage always shows me an average cost basis.

    Also, please don’t mention Apple stock to me right now. I was waiting for cash so I could buy them when they were $151/share. In days, they shot up to $183/share. I completely missed out!

    ARB–Angry Retail Banker

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