The ‘Tax Trick’ Behind This 14% Yield Has a Name: Return of Capital. Here’s Who It Actually Helps

Return of capital (ROC) is one of the more misunderstood concepts in income investing. A distribution can land in your brokerage account every month without necessarily being treated as taxable income in the year you receive it. Instead, the return of capital portion generally reduces your adjusted cost basis (ACB), effectively pushing the tax liability into the future.

Keep collecting return of capital and the basis keeps declining. Once your adjusted cost basis reaches zero, subsequent ROC distributions generally become taxable capital gains. Investors using these ETFs in taxable accounts therefore need to keep careful track of their basis rather than assuming that “tax deferred” means “tax free.”

There’s another complication. Return of capital is a double-edged sword because the tax classification doesn’t tell you whether the underlying investment is actually making money. Destructive ROC occurs when a fund effectively hands investors their own capital back while its net asset value (NAV) steadily deteriorates. Constructive ROC is different. An options strategy can generate economic returns while portfolio management, realized losses, options taxation, and other accounting factors allow some of its distributions to be classified as RoC.

That’s the situation investors should be looking for, and it needs to be monitored carefully. Distribution yield, NAV performance, total return, and adjusted cost basis all matter. One ETF that has so far managed that balancing act is the NEOS Nasdaq-100 High Income ETF (QQQI).

What Is QQQI?

QQQI is an actively managed ETF built around two components. First, the fund maintains long exposure to the Nasdaq-100, giving investors access to 100 of the largest non-financial companies listed on the Nasdaq. That naturally produces a portfolio tilted toward technology and growth stocks, along with the higher volatility that frequently accompanies them.

QQQI then overlays that portfolio with a data-driven options strategy. Rather than mechanically selling calls and surrendering all appreciation above the strike price, the managers can use call spreads by selling a call and using some of the premium to purchase another call at a higher strike.

The short call monetizes some of the Nasdaq-100’s relatively high implied volatility. The purchased call can restore some participation if the index rallies substantially, giving QQQI greater flexibility than a traditional buy-write strategy. That hasn’t allowed QQQI to keep up completely with the Nasdaq-100 during a strong bull market, which is the expected trade-off.

Since inception, QQQI has produced a 57.74% cumulative total return, compared with 43.58% for the Cboe Nasdaq-100 BuyWrite Monthly Index. The Nasdaq-100 itself returned 70.61% over the same period. So far, QQQI has occupied an interesting middle ground. It has substantially outperformed a conventional Nasdaq-100 buy-write strategy while capturing more of the underlying index’s appreciation, all while generating a 14.01% distribution rate.

That income doesn’t come free. Investors are still sacrificing some upside, paying a higher fee than they would for a plain Nasdaq-100 index ETF, and accepting the concentration and volatility associated with growth stocks. For someone primarily interested in maximizing terminal wealth, the long-only index could still be the better fit.

Who Benefits from Return of Capital?

Remember, this strategy only has a tax-deferral advantage when QQQI is held in a taxable brokerage account. Inside an IRA or other tax-advantaged retirement account, tracking return of capital and adjusted cost basis doesn’t provide the same benefit.

QQQI’s Section 19a-1 notice for August estimated that 100% of its distribution consisted of return of capital. That’s only a preliminary estimate, with final tax characterization reported on Form 1099-DIV at year-end. That creates an interesting use case for retirees towards the end of their lifespan.

Suppose someone buys $500,000 of QQQI in a taxable brokerage account, lives off its monthly distributions for years, and ROC gradually reduces their adjusted basis to $300,000. If the shares are still worth $500,000 when they die, the IRS says the basis of inherited property is generally “the fair market value of the property on the date of the individual’s death.”

In that simplified example, an heir could receive a new $500,000 basis rather than inheriting the retiree’s $300,000 adjusted basis. The retiree received years of potentially tax-deferred cash flow, while the accumulated unrealized gain could effectively disappear for federal capital-gains purposes under current step-up rules.

That’s an unusually attractive outcome, but only if the ROC remains constructive. QQQI still needs to generate enough total return to support its 14.01% distribution rate without steadily eroding NAV. Investors using the strategy should therefore monitor both NAV and their adjusted cost basis carefully.

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