Boomers are buying into the promise of monthly income from options ETFs, but there's a tax catch

Covered call ETFs have been widely adopted by baby boomers to meet monthly income needs, but unlike most ETFs, the tax implications can be significant.

Covered call ETFs have gained a following for their ability to generate monthly cash flow. But a tax surprise could be lurking for many investors.

These actively managed funds have different underlying assets and strategies. But the premise is generally the same. Covered call funds hold equities and sell call options or use related derivatives to generate income. Investors receive attractive income yields in exchange for limited capital upside. The tax piece is more complicated, however.

A fund that realizes option premiums, short-term gains or other income still has taxable amounts to distribute. The tax hit can be easy — and costly — for investors to miss, especially since ETFs are typically understood to be tax-efficient investment vehicles, and especially since most investors aren't looking at the tax implications until they receive a 1099-DIV at tax time, the IRS tax document issued by financial services companies to report dividends and related distributions paid to investors during a tax year.

Even if a fund has good returns and a favorable 30-day SEC yield — which measures the net investment income of bond funds or equity funds and is annualized to reflect the yield an investor would expect to earn over the course of a full year — investors need to look under the hood and understand the tax implications of covered call ETFs. "The after-tax net total return might fall below your expectations," said Matthew Smart, chief investment officer at WWM Investments in Chicago.

Here's what investors need to know about covered call ETFs and taxes:

Not all income distributions are created equal

Distributions from covered call funds come in several forms: dividends, capital gain distributions, or non-dividend distributions. The distribution mix can vary by fund and change year to year. Non-dividend distributions are commonly known as return of capital — payment or distribution from a portion of an investor's original principal rather than an economic profit, capital gain, or dividend earnings. And this is where it can get confusing for investors because ROC distributions aren't treated as current income. Instead, they reduce the investment's cost basis by the distribution amount, so they are tax-deferred until shares are sold.

Covered call ETFs take different approaches to distributions. "Some covered call strategies make distributions characterized only as ordinary dividends. Other strategies make distributions that may include all three types. And since investors' individual tax rates vary significantly, there can be a large difference between what investors receive in fund distributions on a pre-tax basis, and what they keep after paying taxes," ProShares wrote in a blog on covered call strategy and tax efficiency.

Investors surprised by cost-basis and delayed taxes

Averytin News Financial update.