Retirees chase monthly income from options

Covered call ETFs have gained popularity with older investors willing to give up market upside for regular monthly cash flow from selling call options.

The tax surprise arrives at filing time

ETFs are typically tax-efficient, but covered call funds distribute income in various forms. Investors often miss the tax hit until they receive IRS form one zero nine nine dash D I V.

After-tax returns fall short of expectations

Even with good returns and favorable thirty-day SEC yield, investors need to understand tax implications.

“The after-tax net total return might fall below your expectations.”

Three types of distributions, three tax rates

Covered call funds distribute dividends, capital gains, or non-dividend distributions. Non-dividend distributions, called return of capital, reduce cost basis and defer taxes until shares sell.

Different funds, different tax mixes

Some covered call strategies distribute only ordinary dividends. Others include all three types. Since individual tax rates vary significantly, pre-tax distributions and after-tax income differ widely.

Return of capital confuses investors

Edwin Retter, senior wealth advisor at Mission Wealth in Melbourne, Florida, says investors are surprised by qualified dividends and ordinary income at tax time and confused by return of capital.

Return of capital delays, not avoids, taxes

Return of capital seems favorable short-term but is the investor's own money returned, reducing cost basis.

“You're not avoiding the taxes; you're just delaying it until you sell.”

Tax-deferred accounts offer shelter

Edwin Retter recommends buying covered call ETFs within tax-deferred accounts such as traditional IRAs. Investors do not worry about taxes until withdrawing money, saving time and taxes.

Tax-cost ratio reveals the real impact

The Morningstar Tax Cost Ratio measures how much a fund's annualized return is reduced by taxes on distributions. Investors can find this on Morningstar dot com by typing the fund ticker.

Tax costs vary widely between funds

J P Morgan Equity Premium Income ETF, ticker J E P I, has a three-year tax cost ratio of three point one one.

Fund growth must outpace distributions

Brent Sullivan, independent tax analyst at Tax Alpha Insider, warns that net asset value must grow faster than the distribution rate. The money has to come from somewhere and cannot just come from new investors.

“The fund's NAV must keep going up to sustain those distributions. It's not magic.”

Bonds offer simpler income alternatives

With the ten-year U S Treasury hovering around five percent, investors can find attractive income in bonds.

Index ETFs offer lower costs and tax efficiency

Vanguard S and P five hundred ETF, ticker V O O, has an expense ratio of zero point zero three percent.

Tech stocks already in covered call funds

Many covered call ETFs hold large tech stocks including Nvidia, Apple, Microsoft, Alphabet, Amazon and Meta that have driven market growth. Investors should know whether these stocks are already well represented in their portfolio.