Covered call ETFs have gained popularity for their ability to generate monthly cash flow. But a tax surprise could threaten many investors.
These actively managed funds have different assets and underlying strategies. But the principle is generally the same. Covered call funds hold stocks and sell call options or use related derivatives to generate income. Investors benefit from attractive returns in exchange for a limited increase in capital. The tax aspect, however, is more complicated.
A fund that earns option premiums, short-term gains, or other income always has taxable amounts to distribute. The tax impact can be easy – and costly – for investors to ignore, especially since ETFs are generally considered tax-advantaged investment vehicles, and especially since most investors don’t consider the tax implications until they receive a 1099-DIV at tax time, the IRS tax document issued by financial services companies to report dividends and related distributions paid to investors during a tax year.
Even if a fund has good returns and a favorable 30-day SEC yield – which measures the net investment income of bond funds or stock funds and is annualized to reflect the return an investor would expect to earn over the course of a full year – investors should look under the hood and understand the tax implications of covered call ETFs. “The net after-tax total return might be lower than your expectations,” 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 equal
Distributions from covered purchase funds come in several forms: dividends, capital gains distributions, or non-dividend distributions. The composition of the distribution may vary by fund and change from year to year. Non-dividend distributions are commonly referred to as return of capital: payment or distribution from a portion of an investor’s initial capital rather than economic profit, capital gain or dividends. And this is where it can get confusing for investors, because ROC distributions are not treated as current income. Instead, they reduce the cost basis of the investment by the amount of the distribution, so they benefit from a tax deferral until the shares are sold.
Covered call ETFs take different approaches to distributions. “Some covered call strategies make distributions characterized only as ordinary dividends. Other strategies make distributions that may include all three types. And because investors’ individual tax rates vary widely, there can be a big difference between what investors receive in pre-tax fund distributions and what they keep after paying their taxes,” ProShares wrote in a blog about the covered call strategy and tax efficiency.
Investors surprised by cost basis and tax delays
Some covered call ETF investors are surprised at tax time by the size of qualified dividends and ordinary income, said Edwin Retter, senior wealth advisor in Mission Wealth’s Melbourne, Florida, office.
They are also confused by the ROC concept. While this looks favorable from a short-term distribution perspective, it is investors’ own money coming back to them, which reduces the cost base. Having a lower cost basis generally increases the investor’s capital gains tax liability at the time of sale.
“You’re not avoiding taxes; you’re just delaying the sale until you sell,” said Aaron Brachman, wealth manager at the Washington Wealth Group of Steward Partners in Washington, DC.
The use of tax-deferred accounts is recommended
Investors who decide to purchase a covered call ETF should ideally do so in a tax-deferred account such as a traditional IRA, Retter said. “I don’t know how many investors think about it that much. They just find out at tax time that they put it in a less tax-advantaged account.”
By investing in a covered call ETF through a traditional IRA, investors don’t have to worry about taxes until they withdraw money from the account. “You can really save a lot of time and taxes by putting it in the right account structure,” Retter said.
The tax-cost ratio is a key measure for assessing
Investors who want to better understand how taxes come into play in a covered call ETF can use a metric known as the cost-tax ratio. The Morningstar Tax Cost Ratio measures the extent to which a fund’s annualized return is reduced by the taxes investors pay on distributions. Investors can enter the ticker of the fund they’re looking for on Morningstar.com, click on the price tab and scroll down to see the tax-cost ratio.
“It’s a flexible tool that can help investors easily compare different time periods, different funds and different categories. Investors pay taxes when they receive a taxable distribution and these costs are just as relevant as the expense ratio in reducing an investor’s net return,” Morningstar wrote in an article explaining the calculation methodology.
For example, the JPMorgan Equity Premium Income ETF (JEPI) has a three-year tax cost ratio of 3.11, according to Morningstar. This means that after-tax returns are reduced by around 3.11 percentage points per year for investors in the highest tax brackets.
Another example is the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ). The fund’s three-year tax cost ratio is 4.30. In contrast, the Neos S&P 500(R) High Income ETF (SPY) has a three-year tax cost ratio of 0.48.
The tax situation can be very specific to ETFs because it depends on how the fund is structured, said Brent Sullivan, an independent tax analyst at Tax Alpha Insider. SPYI has a higher return on capital than some of its peers, reducing the most immediate tax consequences, but there remains a cost basis and fund growth issue that investors need to consider, he added.
Pay attention to NAV
It’s not just taxes that investors need to consider with these funds. “It’s good to look at portfolio returns, and it’s good to look at the tax consequences, but the net asset value has to grow faster than the distribution rate,” Sullivan said. “The net asset value of the fund has to continue to increase to maintain these distributions. It’s not magic. The money has to come from somewhere, and it can’t just come from new investors,” he said.
Investors should also look at a fund’s 30-day SEC yield to get an idea of what the company is generating in terms of revenue. JEPI has a 30-day SEC yield of 7.45%, compared to 11.56% for JEPQ and 0.45% for SPYI.
Consider other income-generating alternatives
Several financial advisors have said they aren’t fans of covered call ETFs for tax, complexity and other reasons.
With the US Treasury at 10 years continuing to hover around 5%, investors have more opportunities to find attractive income in bonds, from ultra-short bond funds to corporate bonds.
“I would rather have someone in a portfolio that is primarily fixed income and hedge interest rate risk with 20 to 40 percent of the portfolio in high-quality growth stocks,” said Andrew Urbanski, founder and chief investment officer at N10 Assets in Greenwich, Connecticut. “If income is not sufficient, draw down capital from the bond or stock portion of the portfolio in a riskier, more profitable way,” he said.
Covered call ETFs cap an investor’s upside potential. In a taxable account, an investor could instead buy an S&P 500 ETF — or a total market ETF to get more exposure to small and mid-caps — collect dividends and make systematic withdrawals through small periodic stock sales after a year for tax efficiency reasons, Retter said.
Index ETFs generally have lower expense ratios than their actively managed counterparts. The Vanguard S&P 500 ETF (VOO) has an expense ratio of 0.03%. The Vanguard Morningstar Total Stock Market ETF (VTI) also has an expense ratio of 0.03%.
In contrast, JEPI and JEPQ each have an annual expense ratio of 0.35%. SPYI has an expense ratio of 0.68%.
Meanwhile, many covered call ETF funds include big tech stocks such as Nvidia, Apple, Microsoft, Alphabet, Amazon and Meta, which have driven market growth. It is therefore important for investors to know if these stocks are already well represented in their portfolio.
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