The Importance of Tax-Efficient Income

The US income tax code is complex, with marginal tax rates varying by individual and family income and the holding period and type of investment. In addition, state and local rates differ across the country.

For example, gains from SPY via ETF options or NVDA from an equity option are taxed as short-term capital gains, when held less than one year. The same goes for swap agreements and equity-linked notes offering derivative exposure to specific securities or indexes. However, as mentioned above, an index option (such as S&P 500 or Nasdaq-100) receives favorable taxation on any gains regardless of the holding period because of their unique classification from the IRS. The official language from IRS form 6781 states, “If your section 1256 contracts produce capital gain or loss, gains or losses on section 1256 contracts open at the end of the year, or terminated during the year, are treated as 60% long term and 40% short term, regardless of how long the contracts were held.” This can have a significant impact on the amount of money that investors get to keep.

EXAMPLE

A married couple with over $731,200 in annual taxable income would face:

• A 37% marginal tax rate on ordinary income and short-term capital gains and a 20% tax rate on qualified dividends and long-term capital gains
• The blended rate for gains from Section 1256 contracts, such as options on broad-based stock indices, would be 26.8%
• Paying a 26.8% tax rate rather than the 37% marginal tax rate on ordinary income would save taxpayers $10,200 per year for each $100,000 in options-based income. Compounding this difference in tax rates can add substantially to portfolio value over ten years.

The hypothetical illustration below shows the compounding effect this can have over time.³

IMPORTANT CALLOUTS

• Portions of the distributions classified as return of capital (ROC) are not taxable in the year they’re received
• A gross yield of 16.26%, rather than 12.00% would be needed in scenario 2 to achieve the after-tax yield from scenario 1
• Income generated from sold index options are taxed as 60% long-term / 40% short-term capital gains, regardless of their holding period
• The blended tax rate in scenario 1 is 10.04%compared to 33.60% in tax scenario 2

³ In this hypothetical scenario, 60% of the distribution was offset via portfolio losses which allowed this portion of the distribution to be classified as a “Return of Capital” (ROC). ROC is non-taxable in the year it’s received because it’s not considered as realized income nor profits. Over time ROC may reduce an investors cost basis in a fund and upon the sale of shares they may be taxed at long term rate (20%). This scenario assumes only the compounding affect of distribution amounts without any capital appreciation/ depreciation. This is for illustrative purposes only. This hypothetical scenario does not reflect the experience of any investor and should not be relied on for investment decisions. NEOS ETFs may incorporate tax loss harvesting within their portfolios to maximize realization of losses to offset gains when applicable. Market conditions may limit the ability to generate tax losses.

Return of Capital Designation…Is it Good, Bad, or Tax Efficient?

In addition to the advantageous tax classification offered to index option contracts shown in the illustration above, another potential tax advantage of option writing ETFs is a “return of capital” classification on all or a part of fund distributions. It’s important to note that “return of capital” is a tax concept and may come from opportunistically harvesting portfolio losses to offset gains. It can be a scary-sounding concept, often confused with the economic concept of “return of principal,” which can have negative consequences.

Return of principal happens when investment funds offer regularly scheduled distribution payments but don’t generate the necessary return streams to support those distribution payments, leading to principal erosion – also known as the economic concept of “return of principal.”

Some potential tax advantages of distributions classified as a “return of capital” are:

• Unlike dividends or interest income, return of capital is not considered income and is not immediately taxable in the year it’s received.
• Instead, it reduces an investor’s cost basis in an ETF, allowing them to convert current fund distributions to long-term capital gains if/when shares are sold.
• The ETF structure allows portfolio losses to be carried forward indefinitely. This flexibility allows losses to be realized in years when needed to offset capital gains while deferring the realization of losses in years when they can’t be immediately used.

Potential Benefits Through Active Management of Options-Based ETFs from NEOS Investments

A standard buy-write strategy, such as the strategy tracked by the Cboe S&P 500 BuyWrite Index, owns an underlying portfolio of stocks and sells one-month call options slightly out-of-the-money on the full portfolio value. This strategy works well in months when the stock market is range-bound, either slightly rising or falling.

In months when the stock market rises sharply, the gains on the portfolio will be limited by the call options that have been sold. A mechanical strategy typically holds positions until maturity and does not intentionally generate tax losses.

An actively managed buy-write strategy like those run by NEOS Investments has the freedom to sell options on less than the total value of the underlying portfolio, ladder multiple options contracts with different levels of moneyness, and opportunistically generate tax losses to offset gains.

A Look at the Equity High-Income Lineup from NEOS Investments

• The NEOS S&P 500 High Income ETF (SPYI) sells covered call options on the S&P 500 Index, seeking to deliver high levels of tax efficient monthly income.
• The NEOS Nasdaq-100 High Income ETF (QQQI) sells covered call options on the Nasdaq 100 Index, seeking to deliver high levels of tax efficient monthly income.
• The NEOS Russell 2000 High Income ETF (IWMI) sells covered call options on the Russell 2000 Index, seeking to deliver high levels of tax efficient monthly income.

Using the NEOS S&P 500 High Income ETF (SPYI) as an example, these potential benefits are apparent when comparing the ETF to the Cboe S&P 500 BuyWrite Monthly Index mentioned above which takes a passive, mechanical approach:

⁴ Performance data quoted represents past performance and is no guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For standardized performance, please call (866) 498-5677 or visit the Fund’s website at https://neosfunds.com/spyi/. Index returns are for informational purposes only and it is not possible to invest directly in an index. Source: US Bank, Morningstar 2025. The hypothetical growth of $10,000 chart reflects a hypothetical investment and assumes reinvestment of dividends and capital gains. Fund expenses, including management fees and other expenses were deducted.

In times of lower market volatility, SPYI’s fund managers have the flexibility to sell multiple call options with varying levels of moneyness and portfolio coverage to generate the desired income target while still leaving prospects for capital appreciation in a rising market environment.

In times of higher market volatility, options prices tend to be higher, and fund managers can either sell fewer options or write them further out of the money to achieve the desired income targets.

The active and systematic nature of SPYI has offered reliable tax-efficient monthly income and strong total return since its inception on 8/29/2022 through 1/31/2025.

• Tax efficiency comes from S&P 500 Index option contracts and opportunistically harvesting portfolio losses
• Prospects for long-term capital appreciation are maintained through a data-driven laddered call writing strategy
• Outperformance during recent market rallies compared to the Cboe S&P 500 BuyWrite Monthly Index is shown above
• Traditional buy-write strategies may fall short in those areas compared to SPYI.

Options Background of the NEOS Team

Troy Cates and Garrett Paolella are co-founders of NEOS Investments and pioneers in the options-based ETF space. Over a decade ago, they created and managed some of the earliest products of their kind that were introduced to the ETF market. NEOS stands for “Next Evolution Options Strategies,” and their current fund lineup combines their unique knowledge of options-based ETFs with the advancements of the ETF structure and industry as a whole. Their goal is to offer multidimensional benefits such as high monthly income generation, tax efficiency, and upside potential – or in some cases – downside protection, in a single exchange-traded product.

Risk and Return of Options-Based Strategies

Beyond the income generation and tax efficiency aspects, covered call strategies are less volatile than long-only stock market investments. While they may sacrifice some upside potential due to their short call positions, the downside return potential slightly improves through the income generated by the sale of the call options. That is, covered call strategies will likely have higher returns in range-bound markets and lower returns in rapidly appreciating markets compared to long-only equity positions, reducing the range of potential returns and volatility.

Continuing to use SPYI as an example, the table below shows the concepts outlined in the previous paragraph.

How to Think About Incorporating Options-based ETFs into Portfolios

Options-based income ETFs can complement or act as an alternative to traditional core equity or income-focused portfolio allocations. These ETFs may be well-suited for investors looking to increase their income potential, improve tax efficiency, and their lower correlation with traditional asset classes.

Complementing Core Equity Allocations: By utilizing options-based income ETFs as a complement to existing equity allocations, investors can pursue long-term capital growth while enhancing their income potential through the strategies embedded in these funds. This approach may allow investors to maintain their core equity exposures and strike a balance between growth and income that aligns with their long-term investment goals.

An Alternative to Income-Focused Investments: Unlike traditional income investments such as bonds or dividend-paying stocks, options-based income ETFs typically provide higher income potential and exhibit lower correlation to interest rate movements. This makes them an appealing alternative for investors looking to diversify their income sources, especially in environments where interest rates are either declining or remain low.

Conclusion

As the options-based ETF space grows, it’s crucial to recognize that not all “options” are created equal. With a wide range of strategies and products available, investors must identify those that align with their goals and risk tolerance. Experienced managers like the ones at NEOS Investments may be able to add value by crafting strategies that focus on multidimensional benefits including high income potential, tax efficiency, and risk management, while also pursuing long- term capital appreciation.