Covered call ETFs have gained popularity for their ability to generate monthly cash flow. But there could be a tax surprise in store for many investors.
These actively managed funds have different underlying assets and strategies. But the premise is generally the same. Covered call funds hold stocks and generate income by selling call options or using related derivatives. Investors receive attractive income yields in exchange for limited capital upside. However, the tax part is more complicated.
Funds that realize option premiums, short-term gains, or other income still have taxable amounts to distribute. While ETFs in particular are generally understood to be tax-efficient investment vehicles, the tax implications can be easily overlooked and costly for investors, especially since most investors do not consider the tax implications until tax time when they receive a 1099-DIV (an IRS tax document issued by financial services companies to report dividends and related distributions paid to investors during a tax year).
Even if the fund’s returns are good and the SEC’s 30-day yield is good (which measures the net investment income of a bond or equity fund and is annualized to reflect the yield an investor would expect to earn in one year), investors should look inside a covered call ETF to understand the tax implications. “Net total returns after taxes may be lower than expected,” said Matthew Smart, chief investment officer at WWM Investments in Chicago.
Here’s what investors need to know about covered call ETFs and taxes.
Not all income distributions are created equal.
Distributions from covered call funds can take several forms, including dividends, capital gain distributions, or non-dividend distributions. The distribution structure varies by fund and can change from year to year. A non-dividend distribution, commonly known as a return of capital, is a payment or distribution of a portion of an investor’s principal rather than economic profit, capital gain, or dividend income. And since ROC distributions are not treated as ordinary income, this can cause confusion for investors. Instead, it reduces the cost basis of the investment by the amount of the distribution, so taxes are deferred until the shares are sold.
Covered call ETFs take a different approach to distribution. “Some covered call strategies create distributions that can be characterized as regular dividends only; other strategies create distributions that include all three types. And because investors’ personal tax rates vary widely, there can be a significant difference between what an investor receives as a fund distribution on a pre-tax basis and what remains after paying taxes,” ProShares writes in its blog on covered call strategies and tax efficiency.
Investors were surprised by cost basis and tax delays
Edwin Retter, senior wealth advisor at Mission Wealth in Melbourne, Fla., says some covered call ETF investors are surprised by the size of their qualified dividends and ordinary income at tax time.
They are also confused by the concept of ROC. In the short term, it looks favorable from a distribution perspective, but the cost base is lower because investors are getting their own money back. Generally, a lower cost basis increases the investor’s capital gains tax liability upon sale.
“You’re not avoiding taxes; you’re just deferring taxes until you sell,” said Aaron Blackman, wealth manager at Steward Partners’ Washington Wealth Group in Washington, D.C.
Recommended use of tax-deferred accounts
Retter said investors who decide to buy covered call ETFs should ideally do so within a tax-deferred account, such as a traditional IRA. “I don’t know how many investors think about it that much. They just find out at tax time that they invested in an account that doesn’t pay as much tax.”
By investing in covered call ETFs through a traditional IRA, investors don’t have to worry about taxes until they withdraw the funds from their account. “You can really save a lot of time and taxes with the right account structure,” Retter says.
Tax cost ratio is an important measure to evaluate
Investors who want to better understand how taxes play a role in covered call ETFs can use a measurement known as the tax cost ratio. The Morningstar Tax Cost Ratio measures how much a fund’s annualized return is reduced by the taxes investors pay on distributions. Investors can enter the ticker of the fund they’re researching on Morningstar.com, click on the price tab, and scroll down to see the tax cost ratio.
“This is a flexible tool that allows investors to easily compare different time periods, different funds, and different categories. Investors pay taxes when they receive taxable distributions, and these costs are just as relevant as expense ratios in reducing investors’ take-home pay,” Morningstar wrote in a paper explaining the calculation.
For example, the JPMorgan Equity Premium Income ETF (Jepi) According to Morningstar, the three-year tax expense ratio is 3.11. This means after-tax returns for investors in the highest tax brackets will decline by approximately 3.11 percentage points per year.
Another example is the JPMorgan Nasdaq Stock Premium Income ETF (JEPQ). The fund’s three-year tax expense ratio is 4.30 times. In contrast, the Neos S&P 500(R) High Income ETF (spy) has a three-year tax expense ratio of 0.48.
Brent Sullivan, an independent tax analyst at Tax Alpha Insider, said the tax situation can be very unique to ETFs because it depends on the structure of the fund. He added that while SPYI has a higher return on capital than some of its peers, and the more immediate tax implications are mitigated, there are still cost base and capital growth issues for investors to consider.
Focus on NAV
Taxes aren’t the only thing investors have to consider with these funds. “It’s good to look at portfolio returns, it’s good to look at tax effects, but NAV has to grow faster than distributions,” Sullivan said. “To maintain those distributions, the fund’s NAV has to keep going up. It’s not magic. The money has to come from somewhere, and it can’t just come from new investors.”
Investors should also look at a fund’s 30-day SEC yield to get an idea of what kind of income the company is generating. JEPI’s 30-day SEC yield is 7.45%, while JEPQ’s is 11.56% and SPYI’s is 0.45%.
Consider other means of income generation
Multiple financial advisors said they are not fans of covered call ETFs for tax, complexity and other reasons.
and 10 years US Treasury While interest rates remain hovering around 5%, investors have more opportunities to earn attractive income from bonds, from very short-term bond funds to corporate bonds.
“We’d prefer someone who has a primarily fixed-income portfolio and hedges interest rate risk with 20 to 40 percent of their portfolio in high-quality growth stocks,” said Andrew Urbanski, founder and chief investment officer at N10 Asset in Greenwich, Conn. “If you don’t have enough income, find a more risky and cost-effective way to withdraw principal from the bond or equity portion of your portfolio,” he said.
Covered call ETFs limit the upside for investors. In a taxable account, investors could instead buy an S&P 500 ETF or a total market ETF to increase mid- and small-cap exposure, collect dividends, and make scheduled withdrawals by periodically selling small amounts of shares after a year for tax benefits, Retter said.
Index-based ETFs generally have lower expense ratios than actively managed ETFs. Vanguard S&P 500 ETF (VOO) has an expense ratio of 0.03%. Vanguard Morningstar Total Stock Market ETF (VTI)’s expense ratio is also 0.03%.
In contrast, JEPI and JEPQ each have an annual expense ratio of 0.35%. SPYI’s expense ratio is 0.68%.
On the other hand, many covered call ETF funds include large-cap tech stocks such as Nvidia, Apple, Microsoft, Alphabet, Amazon, and Meta, which have been driving market growth, so it’s important for investors to know whether these stocks are already well incorporated into their portfolios.
