Here is a financial product with an impeccable sales pitch: give us your money, we will own some stocks, we will sell call options against them, and once a month we will mail you — well, direct-deposit you — a check. Regular income, like a paycheck or a pension, except you’re retired and it’s your portfolio doing the work. Covered call ETFs have attracted a devoted following on exactly this pitch, and as CNBC reports, many of the faithful are about to learn that the tax treatment of their monthly bounty is, to put it gently, more complicated than the marketing.
The setup is simple enough: the fund holds equities and sells call options or uses related derivatives, collecting premiums that get distributed to investors as an attractive yield. In exchange, investors cap their capital upside — if the market rips, the fund sold away the rally. Fair trade, disclosed trade, fine. The catch arrives later, when the 1099-DIV shows up. “The after-tax net total return might fall below your expectations,” Matthew Smart, chief investment officer at WWM Investments in Chicago, put it. ETFs carry a general reputation for tax efficiency, and this particular species of ETF is where that reputation goes to die.
Return of whose capital, now?
Distributions from these funds come in three flavors: dividends, capital gain distributions, and non-dividend distributions, better known as return of capital. Return of capital sounds like income and feels like income. It is your own principal being handed back to you. It isn’t taxed as current income — instead it reduces your cost basis by the distribution amount, deferring the tax until you sell, at which point the lower basis means a bigger capital gain. “You’re not avoiding the taxes; you’re just delaying it until you sell,” as Aaron Brachman, a wealth manager at the Washington Wealth Group of Steward Partners, told CNBC. Edwin Retter, a senior wealth advisor at Mission Wealth’s Melbourne, Florida office, says clients are routinely surprised by the size of the qualified dividends and ordinary income, and baffled by the ROC concept into the bargain.
And the mix varies, which is part of the fun. “Some covered call strategies make distributions characterized only as ordinary dividends. Other strategies make distributions that may include all three types,” ProShares wrote in a blog post, noting that the gap between what investors receive pre-tax and keep post-tax can be large depending on their bracket.
Look under the hood
If you want a number to compare funds, Morningstar offers the tax-cost ratio, which measures how much of a fund’s annualized return is eaten by taxes on distributions. Type a ticker into Morningstar.com, click the price tab, scroll down. The results are striking. The JPMorgan Equity Premium Income ETF (JEPI) has a three-year tax cost ratio of 3.11 — meaning about 3.11 percentage points of annual return go to taxes for top-bracket investors. Its sibling JEPQ clocks in at 4.30. The Neos S&P 500 High Income ETF (SPYI), meanwhile, sits at just 0.48, largely because its distributions lean toward return of capital — which, per Brent Sullivan, an independent tax analyst at Tax Alpha Insider, lowers the immediate tax pain but leaves investors with the cost-basis problem and a question about the fund’s growth.
Sullivan has another instruction worth tattooing on the product: watch the NAV. “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,” he 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.” That last sentence is doing a lot of quiet work. A fund paying out 11% while its assets tread water is not generating income; it is running a slow-motion liquidation with a yield label on it. For comparison: JEPI’s 30-day SEC yield is 7.45%, JEPQ’s is 11.56%, and SPYI’s is 0.45% — a sign of just how differently these products are put together.
The professional consensus on where to hold these things, if you must hold them: a traditional IRA or other tax-deferred account, so the tax questions can wait until withdrawal. “I don’t know how many investors give so much thought to that,” Retter said. “They just find out at tax time.” And several advisors told CNBC they’d skip the category entirely. With the 10-year Treasury hovering around 5%, Andrew Urbanski of N10 Assets in Greenwich, Connecticut would rather hold predominantly fixed income, hedge the rate risk with 20% to 40% in high-quality growth stocks, and draw down principal as needed. Retter suggests a taxable investor might just buy a plain S&P 500 or total-market fund — VOO or VTI, each at a 0.03% expense ratio, versus 0.35% for JEPI and JEPQ and 0.68% for SPYI — collect dividends and make small periodic share sales after a year.
One more wrinkle: these funds are stuffed with the Nvidias, Apples, Microsofts, Alphabets, Amazons and Metas that have been driving the market, so an investor whose portfolio already leans tech is paying 0.35% to cap the upside on stocks they already own. The income is real. So is everything else.