Covered call ETFs hold stocks and sell options on them to pay out monthly income. According to CNBC, that income can come with a tax bill many investors only notice when their tax forms arrive. The number that decides how much this matters is Morningstar's tax cost ratio. CNBC reports a three-year figure of 3.11 for the JPMorgan Equity Premium Income ETF (JEPI), 4.30 for the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ), and 0.48 for the Neos S&P 500 High Income ETF (SPYI). For JEPI, CNBC says that means after-tax returns are reduced by about 3.11 percentage points a year for investors in the highest tax brackets.
The background you need
Call option. A call option is a contract that gives its buyer the right, but not the obligation, to buy a stock at a set price (the strike) before a set date. The buyer pays the seller up front for that right. That payment is the premium.
Covered call. You sell a covered call when you already own the stock. You collect the premium now. In exchange, if the stock rises above the strike, your gain stops there, because the buyer can take your shares at the strike price. CNBC describes the trade the same way: investors get attractive income yields in exchange for limited capital upside.
Here is an analogy. You own a car. A neighbor pays you a fee for the right to buy it from you at a fixed price any time this month. If car prices stay flat, you keep the car and the fee. If prices jump, the neighbor buys at the old price and you miss the jump. The analogy breaks in two places. Options are priced by a live market, not haggled. And a fund repeats this trade over and over across a whole portfolio, often using related derivatives rather than plain calls, according to CNBC.
Why ETFs are seen as tax-efficient. Most stock index ETFs rarely pay out capital gains. Because of how ETF shares are created and redeemed, the fund can usually shed low-cost shares without selling them on the market. So you mostly pay tax when you sell, on your own schedule. Covered call funds are different. CNBC notes that a fund that realizes option premiums, short-term gains or other income still has taxable amounts to distribute. The ETF wrapper does not make that income disappear.
The three kinds of distribution. CNBC lists them as dividends, capital gain distributions, and non-dividend distributions. Dividends split into qualified dividends, which get the lower long-term capital gains rates if holding rules are met, and ordinary income, which is taxed at your regular income rate. The non-dividend kind is usually called return of capital (ROC). ROC is part of your own money coming back to you. It is not taxed when paid. Instead it lowers your cost basis, which is the price the IRS treats you as having paid for your shares. A lower basis means a bigger taxable gain when you eventually sell. One advisor put it this way to CNBC: "You're not avoiding the taxes; you're just delaying it until you sell."
The 1099-DIV. This is the form your broker sends after the year ends. It reports your distributions and how each one is classified. CNBC says this is often the first time investors look at the tax side.
Tax cost ratio. Morningstar's measure of how much a fund's annualized return is reduced by the taxes investors pay on distributions. You can find it by searching a ticker on Morningstar.com, opening the price tab, and scrolling down, according to CNBC.
What actually changed
No tax rule changed. The treatment of dividends, option income, and return of capital described in the CNBC report was already in place. What is new is the attention. CNBC says covered call ETFs have gained a following for their monthly cash flow. Edwin Retter of Mission Wealth told CNBC that some investors are surprised at tax time by how large the qualified dividends and ordinary income turn out to be, and confused by the ROC concept.
The report also puts side-by-side numbers on the problem. Beyond the tax cost ratios, CNBC lists 30-day SEC yields of 7.45% for JEPI, 11.56% for JEPQ, and 0.45% for SPYI. It lists expense ratios of 0.35% for both JEPI and JEPQ and 0.68% for SPYI, compared with 0.03% for the Vanguard index ETFs VOO and VTI.
The backdrop matters too. CNBC notes the 10-year U.S. Treasury is hovering around 5%, which gives income seekers more options in bonds.
One point to hold onto: CNBC says the distribution mix can vary by fund and change year to year. A fund's past classification is not a promise about next year's.
What it means for you
The tax cost ratio is the lever because it converts a vague worry into a yearly cost you can compare. Two funds can advertise similar income. If one pays mostly ordinary income and the other pays more ROC, what you keep after tax in a taxable account can differ a lot. Morningstar, quoted by CNBC, argues these tax costs are as relevant as the expense ratio. Using CNBC's figures, JEPI's 3.11 tax cost ratio is many times its 0.35% expense ratio.
Three checks follow from that.
Check the account first. Retter told CNBC that buyers should ideally hold covered call ETFs in a tax-deferred account such as a traditional IRA, where you owe nothing until you withdraw. In a taxable brokerage account, every distribution classified as income shows up on that year's return.
Read a low ratio carefully. By its definition, the ratio measures taxes on distributions. ROC is not taxed when paid, so tax you defer by lowering your basis would not show up in it. Brent Sullivan of Tax Alpha Insider told CNBC that SPYI has a higher return of capital than some peers, which lowers the more immediate tax hit, but that there is still a cost-basis and fund growth issue to consider. He also said the tax picture depends on how each fund is structured.
Watch NAV, not just payouts. NAV, or net asset value, is what the fund's holdings are worth per share. Sullivan told CNBC that "NAV has to grow faster than the distribution rate" for payouts to be sustained. If NAV shrinks while distributions continue, part of your income is your own principal returning.
Two smaller items. CNBC notes many of these funds hold the same large tech names, such as Nvidia, Apple, and Microsoft, that may already dominate your portfolio. And several advisors told CNBC they prefer other routes. Retter described holding a broad index ETF in a taxable account and making small periodic share sales after a year. Andrew Urbanski of N10 Assets described a mostly fixed-income portfolio with a slice of high-quality growth stocks. These are approaches the advisors described, not a ranking.
The tax cost ratio figures CNBC cites describe the reduction for investors in the highest tax brackets. Your own drag depends on your bracket and your account type. In a traditional IRA, distributions are not taxed each year, so the ratio says little about your situation there.
What we don't know yet
- How 2026 distributions will be classified. CNBC says the mix changes year to year. The three-year ratios look backward.
- Why SPYI's SEC yield is so much lower than the others. CNBC reports 0.45% for SPYI against 7.45% and 11.56% for the JPMorgan funds, but does not explain the gap or how it relates to SPYI's distributions.
- What the deferred tax eventually costs. For ROC-heavy funds, the bill depends on when you sell, your bracket then, and how far your basis has fallen. The report does not estimate it.
- How widespread the surprise is. CNBC relies on advisor accounts, not data on how many investors hold these funds in taxable accounts.
Originally published at pickuma.com. Subscribe to the RSS or follow @pickuma.bsky.social for new reviews.
Top comments (0)