Return of Capital Distributions' Tax Advantages

In a year of economic challenges, income seeking strategies continue to be enormously popular with advisors and investors. Dividends are one of the best-understood forms of income, while distributions like return of capital (ROC) remain a murky topic for many, but are worth understanding because of their tax implications and savings.

ROC is a payment back to the investor of the original money invested, either on a monthly or quarterly basis, as other income distributions such as dividends. What’s unique about it is that because it’s returning an investor’s original capital to them, it incurs no taxes at the end of the year as long as the shares are still held. Capital gains are not realized until the shares of the ETF are sold, but can be outsized as the cost basis is gradually being reduced each year, leading to greater capital gain potential when sold.

Let’s step through an example: an advisor purchases 100 shares of an ETF for $10 per share, equating to $1,000 and a cost basis per share of $10. At the end of the year, the fund paid out total distributions of $3 per share (totaling $300) with $2 per share categorized as regular income and interest on the 1099-DIV and $1 per share classified as ROC. You would pay relevant taxes on the $2 per share distributions and no taxes on the $1 ROC, although your cost basis per share would now drop to $9 per share.

That’s important because should you then turn around and sell your shares the next year, you would be selling at a $9 cost basis, meaning that any capital gains incurred when the shares are sold would be larger by $1 per share.

ROC distributions are beneficial for the tax deferment they offer portfolios, allowing advisors and investors to better control taxable income within a given year. The tax-efficient ETFs from NEOS offer exposure to familiar allocations through equities, bonds, and cash alternatives (via ultra-short Treasuries) while also utilizing options to seek to generate tax-efficient high monthly income that includes ROC distributions.

Income for the funds is added through options utilizing two different approaches: the NEOS S&P 500 High Income ETF (SPYI B+) writes call spreads on equities, while the NEOS Enhanced Income Aggregate Bond ETF (BNDI B) and the NEOS Enhanced Income Cash Alternative ETF (CSHI ) utilize put spreads. All three funds offer ROC distributions as part of their monthly income payments.

• SPYI had estimated distributions of $3.30 per share on a book basis of 90% ROC and 10% net investment income as of March 23, 2023.
• BNDI had estimated distributions of $1.42 per share on a book basis of 55% ROC and 45% net investment income as of March 23, 2023
• CSHI had estimated distributions of $1.47 per share on a book basis of 43% ROC and 57% net investment income as of March 23, 2023.

All distribution estimates are not for tax reporting purposes and distributions breakdown and sources could change, depending on the individual fund’s performance over the course of the rest of the year as well as any changes in tax regulations, per NEOS. Only the 1099-DIV issued at the end of the year gives finalized, accurate distribution breakdowns for tax reporting purposes.

All three funds use S&P 500 index options classified as Section 1256 contracts that have favorable tax rates: 60% of capital gains from the premiums are taxed as long-term, and 40% are taxed as short-term, regardless of how long the options were held. This can offer noteworthy tax advantages, and the fund’s managers may also engage in tax-loss harvesting opportunities throughout the year on the options.

For more news, information, and analysis, visit the Tax Efficient Income Channel.