This Tax-Efficient ETF Yields 12%. Here’s How Much of the Monthly Payout May Avoid Current Taxes

The newest generation of options-income ETFs has tried to solve one of the bigger problems with their predecessors: taxes. Historically, a large portion of the distributions generated by options strategies could end up categorized as ordinary income, which isn’t particularly attractive if you’re holding the ETF in a taxable brokerage account.

Today’s more tax-conscious options ETFs are increasingly designed around return of capital (ROC). A return of capital distribution generally isn’t immediately taxable. Instead, it reduces your adjusted cost basis in the investment, effectively deferring the tax liability until you eventually sell your shares. Uncle Sam eventually gets his fill when you sell, but you’ve potentially deferred the tax bill for years. Once your adjusted cost basis reaches zero, however, additional return of capital distributions generally become taxable capital gains.

Return of capital has long been common among pass-through investments such as master limited partnerships (MLPs), but options-based ETFs can use a variety of portfolio management and tax techniques to achieve similar results. One particularly popular option (pun intended) is the NEOS S&P 500 High Income ETF (SPYI). It currently offers a double-digit distribution rate, and according to its latest preliminary tax notice, the overwhelming majority of its most recent distribution was estimated to be return of capital. Here’s what investors need to know.

What Is SPYI?

SPYI is an actively managed ETF with two primary components. First, the fund maintains long exposure to a portfolio designed to broadly track the S&P 500. That gives shareholders exposure to the same large-cap U.S. companies that form the foundation of many retirement portfolios. The second component is where things get interesting. SPYI overlays that equity portfolio with a data-driven call spread strategy designed to generate monthly income while preserving some participation in rising markets.

A traditional covered call strategy sells call options against stocks the investor already owns. The investor collects an upfront premium, but if the market rises substantially above the option’s strike price, much of that additional upside is sacrificed. A call spread modifies this payoff. SPYI can sell a call and then use some of the premium received to purchase another call with a higher strike price. The short call generates income, while the purchased call can restore some upside participation if stocks rally sufficiently far.

So far, the approach has worked reasonably well. After deducting its 0.68% management expense ratio, SPYI currently offers a 12.04% distribution rate based on its most recent payout annualized against net asset value (NAV). Since inception, SPYI has generated a 75.14% cumulative total return, compared with 57.92% for the Cboe S&P 500 BuyWrite Monthly Index. However, the trade-off inherent in options-income investing remains apparent. A plain-vanilla S&P 500 index produced a 101.83% total return over the same period.

For an investor primarily concerned with maximizing long-term total return, simply owning the S&P 500 would therefore have been the better choice. SPYI’s appeal is its ability to convert more of that return into regular monthly cash distributions while retaining more upside potential than a traditional buy-write strategy.

How Tax Efficient Is SPYI?

If you own SPYI in a taxable account, one document worth watching is the fund’s Section 19a-1 notice. A 19a-1 notice provides shareholders with a preliminary estimate of where a fund’s distribution came from. Among other things, it can estimate how much of a particular payout represents net investment income, capital gains, or return of capital.

The word “estimate” is important. A 19a-1 notice does not determine how your distribution will ultimately be treated for federal income tax purposes. The final characterization is determined after the fund completes its year-end accounting and is reported to shareholders on Form 1099-DIV.

Still, SPYI’s latest August notice provides an indication of how tax-efficient its distributions could potentially be. The ETF paid $0.5237 per share, of which approximately 97% was estimated to be return of capital. Only around 3% was estimated to represent net investment income.

If that characterization ultimately holds at year-end, the vast majority of the distribution would generally avoid current taxation and instead reduce the shareholder’s adjusted cost basis. For someone holding SPYI for many years, that can provide a meaningful tax-deferral benefit compared with receiving an equivalent amount of ordinary taxable income each month.

It’s also important to distinguish constructive return of capital from destructive return of capital. A fund can technically produce a large distribution simply by handing investors portions of their original investment back while steadily eroding NAV. A high distribution rate by itself therefore tells you very little about whether an income strategy is actually working.

So far, SPYI’s return of capital has been constructive. Even after accounting for its substantial monthly distributions, its NAV has compounded positively since inception. Its roughly 12% distribution rate is also within the range of total returns U.S. equities have generated during the strong market environment of recent years.

I’d become considerably more skeptical as distribution targets move much higher. At some point, a fund either needs enough underlying investment returns to support the payout, has to accept additional risk to generate it, or risks gradually eroding its capital. SPYI has so far managed that balance relatively well.

Contact [email protected] for any questions or corrections.