Aiming to Maximize Returns and Minimize Taxes: 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 return of capital distributions. While some investors may view return of capital as a negative, there are several reasons why it may offer an added layer of tax efficiency.

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 Factors Might Investors Want to Consider?

Return of capital can help lower an investor's current tax liability. By reducing the amount of taxable income an investor receives, return of capital can potentially reduce the amount of taxes owed in the year the distribution is received. This may be especially favorable for investors in higher tax brackets.
Return of capital 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 tax efficiency of return of capital distributions 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 experienced portfolio management team behind the NEOS ETFs have decades of experience creating and managing options-based ETFs. When possible, they seek to find losses in each ETF's portfolio that can be used to offset gains, potentially helping a portion of Fund distributions receive a return of capital designation.

In addition to each ETFs primary goal of offering monthly income and tax efficiency, we seek to maintain or grow each fund’s net asset value (NAV) over time, so that we don't erode an investors original investment, while aiming to pay out a reliable and tax-efficient monthly income distribution.

Additionally, a unique feature within the ETF product structure is that portfolio losses can be indefinitely carried forward, and can be used at opportune times to offset gains in our ETF's equity or option portfolios, 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.

Related Topics:

NEOS ETF Lineup Overview

Seeking Tax-Efficient Monthly Income? NEOS ETFs aim to deliver the next evolution of options strategies, where seeking income is the outcome.

Understanding Different Types of Yield

We'll explain the difference between 30-day SEC yield, distribution yield, and dividend yield - that investors can use to evaluate the performance of their ETFs.

Investors should carefully consider the investment objectives, risks, charges and expenses of Exchange Traded Funds (ETFs) before investing. To obtain an ETF's prospectus containing this and other important information, please call (866) 498-5677 or view/download a prospectus here: SPYI | QQQI | BNDI | CSHI. Please read the prospectus carefully before you invest.

An investment in NEOS ETFs involve risk, including possible loss of principal. The equity securities purchased by the Funds may involve large price swings and potential for loss.

The use of derivative instruments involves risks different from, or possibly greater than, the risks associated with investing directly in securities and other traditional investments. These risks include (i) the risk that the counterparty to a derivative transaction may not fulfill its contractual obligations; (ii) risk of mispricing or improper valuation; and (iii) the risk that changes in the value of the derivative may not correlate perfectly with the underlying asset, rate or index. Derivative prices are highly volatile and may fluctuate substantially during a short period of time. The use of leverage by the Fund, such as borrowing money to purchase securities or the use of options, will cause the Fund to incur additional expenses and magnify the Fund’s gains or losses. The earnings and prospects of small and medium sized companies are more volatile than larger companies and may experience higher failure rates than larger companies. Small and medium sized companies normally have a lower trading volume than larger companies, which may tend to make their market price fall more disproportionately than larger companies in response to selling pressures and may have limited markets, product lines, or financial resources and lack management experience. The funds are new with a limited operating history.

All references to tax matters are provided for informational purposes only and should not be considered tax advice and cannot be used for the purpose of avoiding tax penalties. Investors seeking tax advice should consult an independent tax advisor.

The information on this website does not constitute investment advice or a recommendation of any products, strategies, or services. Investors should consult with a financial professional regarding their individual circumstances before making investment decisions. NEOS Funds or its affiliates, nor Foreside Fund Services, LLC, or its affiliates accept any responsibility for loss arising from the use of the information contained herein.

NEOS ETFs are distributed by Foreside Fund Services, LLC.

Definitions:

Option: Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.

Distribution Yield: The annual yield an investor would receive if the most recent fund distribution remained the same going forward. The distribution yield represents a single distribution from the Fund and is not a representation of the Fund's total return. The distribution yield is calculated by multiplying the most recent distribution by 12 in order to annualize it, and then dividing by the Fund's NAV.

30-day SEC Yield: A calculation based on a formula mandated by the Securities and Exchange Commission (SEC) that calculates a fund's hypothetical annualized income, as a percentage of its assets. A security's income, for the purposes of this calculation, is based on the current market yield to maturity (in the case of bonds) or projected dividend yield (for stocks) of the fund's holdings over a trailing 30-day period. This hypothetical income will differ (at times, significantly) from the fund's actual experience; as a result, income distributions from the fund may be higher or lower than implied by the SEC yield.

Tax Loss Harvesting: The timely selling of securities at a loss in order to offset the amount of capital gains tax due on the sale of other securities at a profit.