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: