- Reader Case: Future Empty Nesters - September 25, 2023
- Full Circle - September 11, 2023
- Yield To Maturity Might Be Indicating a Bottom in the Bond Market - August 21, 2023
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:
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.
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, 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.
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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