Aiming to Maximize Returns and Minimize Taxes: The Potential Benefits of Return of Capital Distributions in Option-Writing ETFs

By: NEOS Investments

ETFs that utilize option writing strategies to generate income can be an attractive option for investors looking to enhance portfolio income or manage risk. Options-based ETFs focused on generating reliable income for investors may also provide the added benefit of return of capital distributions. While some investors may view return of capital as a negative, there are several reasons why it can be beneficial, especially from a tax perspective.

What Is “Return of Capital” in an ETF?

Return of capital is a distribution made by an ETF to its investors that is classified as a return of the investor's original investment. Unlike dividends or interest income, return of capital is not considered income, and is not immediately taxable. Instead, it reduces the investor's cost basis in the ETF, which can potentially reduce the amount of capital gains tax owed when the investor sells their shares. Return of capital can be particularly useful for ETFs that use option writing strategies to generate income.

What Are Some of the Potential Benefits?

  • One of the key tax benefits of return of capital is that it can help lower an investor's current tax liability. By reducing the amount of taxable income the investor receives, return of capital can potentially reduce the amount of taxes owed in the year the distribution is received. This can be especially beneficial for investors in higher tax brackets.
  • Another potential benefit of return of capital is that it can help investors manage their cash flow needs. By returning a portion of the investor's original investment, return of capital can provide investors with a steady stream of cash flow without requiring them to sell assets. This can be particularly useful for retirees or others who rely on investment income to meet their living expenses.
  • Finally, return of capital can potentially help investors generate higher after-tax monthly income distributions. Because return of capital is not immediately taxable, it can help investors reduce their current tax liability and potentially boost their after-tax returns.

Return of Capital in NEOS ETFs

Options-based income ETFs from NEOS aim to harness the benefits of return of capital for investors without eroding their underlying principle. Each ETF seeks to fund a portion of its monthly income distributions from sold index option premium, which is converted to capital gains, and then paid out to investors on a monthly basis.

The goal is to maintain or grow each fund’s net asset value (NAV) over time, while paying out a reliable and tax-efficient monthly income distribution. Additionally, within the ETF structure, portfolio losses can be carried forward at opportune times to offset gains in a fund’s option portfolio, helping to potentially offer a high monthly yield with minimal tax liabilities.

While “return of capital” can sound like a negative characteristic, it can be a valuable component of ETFs that use option writing strategies, particularly from a tax perspective. As with any investment, investors should carefully consider the risks and benefits before making any investment decisions.

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