Covered call ETFs have gained a following for their ability to generate monthly cash flow. But a tax surprise could be lurking for many investors.
These actively managed funds have different underlying assets and strategies. But the premise is generally the same. Covered call funds hold equities and sell call options or use related derivatives to generate income. Investors receive attractive income yields in exchange for limited capital upside. The tax piece is more complicated, however.
A fund that realizes option premiums, short-term gains or other income still has taxable amounts to distribute. The tax hit can be easy — and costly — for investors to miss, especially since ETFs are typically understood to be tax-efficient investment vehicles, and especially since most investors aren't looking at 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 equity funds and is annualized to reflect the yield an investor would expect to earn over the course of a full year — investors need to look under the hood and understand the tax implications of covered call ETFs. "The after-tax net total return might fall below 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 created equal
Distributions from covered call funds come in several forms: dividends, capital gain distributions, or non-dividend distributions. The distribution mix can vary by fund and change year to year. Non-dividend distributions are commonly known as return of capital — payment or distribution from a portion of an investor's original principal rather than an economic profit, capital gain, or dividend earnings. And this is where it can get confusing for investors because ROC distributions aren't treated as current income. Instead, they reduce the investment's cost basis by the distribution amount, so they are tax-deferred until 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 since investors' individual tax rates vary significantly, there can be a large difference between what investors receive in fund distributions on a pre-tax basis, and what they keep after paying taxes," ProShares wrote in a blog on covered call strategy and tax efficiency.
Investors surprised by cost-basis and delayed taxes
Some covered call ETF investors are surprised at tax time by the magnitude of the qualified dividends and ordinary income, said Edwin Retter, senior wealth advisor in the Melbourne, Florida, office of Mission Wealth.
They are also confused by the ROC concept. While it seems favorable from a distribution standpoint in the short term, it's investors' own money coming back to them, which reduces the cost basis. Having a lower cost basis generally increases the investor's capital gains tax liability at the time of sale.
"You're not avoiding the taxes; you're just delaying it until you sell," said Aaron Brachman, wealth manager at the Washington Wealth Group of Steward Partners in Washington, D.C.
Use of tax-deferred accounts is recommended
Investors who decide to purchase a covered call ETF should ideally do so within a tax-deferred account such as a traditional IRA, Retter said. "I don't know how many investors give so much thought to that. They just find out at tax time that they've put it in a less tax-desirable account."
By investing in a covered call ETF through a traditional IRA, investors don't have to worry about taxes until they pull money out of the account. "You can really save a lot of time and taxes by putting it in the right account structure," Retter said.
Tax-cost ratio is a key measure to evaluate
Investors who want to better understand how taxes come into play in a covered call ETF 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 type in the ticker of the fund they are researching on Morningstar.com, click on the price tab, and scroll down to see the tax-cost ratio.
"It is 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 take-home return," Morningstar wrote in a paper explaining the methodology for the calculation.
For instance, the JPMorgan Equity Premium Income ETF (JEPI) has a three-year tax cost ratio of 3.11, according to Morningstar. That means after-tax returns are reduced by about 3.11 percentage points annually 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. By contrast, the Neos S&P 500(R) High Income ETF (SPYI) has a three-year tax cost ratio of 0.48.
The tax picture can be very ETF-specific 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 of capital than some of its peers, lowering the more immediate tax consequences, but there's still a cost-basis and fund growth issue for investors to consider, he added.
Pay attention to NAV
It's not just taxes investors have to consider with these funds. "It's good to look at the portfolio returns, and it's good to look at tax consequences, but NAV has to grow faster than the distribution rate," Sullivan said. "The fund's NAV must keep going up to sustain those 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 a sense of what the company is generating in terms of income. JEPI has a 30-day SEC yield of 7.45%, compared with JEPQ's 11.56%, and SPYI's 0.45%.
Consider other income-generation alternatives
Several financial advisors said they aren't fans of covered call ETFs for tax, complexity and other reasons.
With the 10-year U.S. Treasury continuing to hover around 5%, there are more opportunities for investors to find attractive income in bonds, from ultra-short bond funds to corporate bonds.
"I'd rather have a person in a portfolio that's predominantly fixed income and hedge the interest rate risk with 20% to 40% of the portfolio in high-quality growth stocks," said Andrew Urbanski, founder and chief investment officer at N10 Assets in Greenwich, Connecticut. "If the income isn't enough, draw on the principal from the bond or stock portion of the portfolio in a way that's more risk and cost-efficient," he said.
Covered call ETFs do cap an investor's upside. In a taxable account, an investor might instead buy an S&P 500 ETF — or a total market ETF to get more small and mid-cap exposure — collect the dividends, and make systematic withdrawals through small periodic share sales after a year for tax-efficiency reasons, Retter said.
Index-based 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%.
By contrast, JEPI and JEPQ each have an annual expense ratio of 0.35%. SPYI has an expense ratio of 0.68%.
Meanwhile, many of the covered call ETF funds include the large tech stocks such as Nvidia, Apple, Microsoft, Alphabet, Amazon and Meta that have been driving the market's growth, so it is important for investors to know whether these stocks are already well represented in their portfolio.