A Simple Nasdaq ETF Swap That Shields Your Income From the IRS

The high volatility of the Nasdaq-100 has led to a proliferation of derivative income ETFs designed to transform that volatility into cash flow. Most do this by selling upside through options, whether via traditional covered calls or more sophisticated option overlays that exchange part of the market’s future appreciation for current income.

One of the best-known examples is the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ). For a relatively low 0.35% expense ratio, the fund combines an actively managed portfolio of stocks selected primarily from the Nasdaq-100 with equity-linked notes (ELNs) that replicate a covered call strategy. The result is a substantial 12.87% 30-day SEC yield.

There’s one catch. Because JEPQ generates much of its income through ELNs, a significant portion of its distributions is generally taxed as ordinary income. Outside of tax-advantaged accounts like a Roth IRA, that can create considerable tax drag. For investors who prioritize after-tax income, there are alternatives that produce similarly high yields while benefiting from substantially more favorable tax treatment, primarily through return of capital.

What Is Return of Capital?

Return of capital (ROC) refers to distributions paid in excess of a fund’s net investment income for tax purposes. Options-based ETFs frequently generate return of capital because of how option premiums, realized gains, losses, and various tax-management techniques are treated under the tax code

Return of capital sometimes gets an unfair reputation. In some cases, it deserves the criticism. Funds experiencing persistent net asset value (NAV) erosion may simply be returning investors’ own capital to maintain an artificially high headline yield, gradually shrinking the underlying asset base over time. Constructive return of capital is different. When generated through legitimate tax-management strategies, return of capital can improve tax efficiency without necessarily indicating economic deterioration.

Unlike ordinary income, ROC generally isn’t immediately taxable. Instead, it reduces an investor’s adjusted cost basis, effectively deferring capital gains taxes until the shares are eventually sold, allowing investors greater control over when taxes are recognized. The primary exception occurs once an investor’s cost basis reaches zero, after which additional return of capital distributions generally become immediately taxable as capital gains.

What to Switch JEPQ For

I have a soft spot for the NEOS Nasdaq-100 High Income ETF (QQQI). Unlike JEPQ, QQQI simply owns the Nasdaq-100 stocks directly and overlays them with a data-driven covered call strategy using NDX index options. Those index options are Section 1256 contracts, meaning gains and losses receive the favorable 60/40 blended tax treatment inside the fund, with 60% treated as long-term capital gains and 40% as short-term capital gains regardless of how long the options were actually held.

QQQI also actively engages in tax-loss harvesting within the portfolio, further improving the tax characteristics of its distributions. The result is that much of the fund’s payout has historically been classified as return of capital. Based on its most recent July 19a-1 notice, the latest monthly distribution was estimated to consist of 100% return of capital. Investors should remember, however, that 19a-1 notices are only estimates. The final tax treatment won’t be known until the fund issues its year-end Form 1099-DIV.

The current income is also compelling. QQQI currently offers a 14.01% distribution yield, exceeding that of JEPQ while potentially delivering much better after-tax cash flow for investors holding the ETF in taxable brokerage accounts. However, QQQI is pricier than JEPQ with a 0.68% expense ratio.

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