How To Beat The Tax Man With Covered Calls
The covered call strategy has some very strong advantages. It has a few drawbacks as well.
On the positive side of the ledger, this strategy has the ability to generate attractive and reliable income on a monthly basis. In fact, it's not unreasonable to shoot for as much as 25% per year on a consistent basis. (Depending on a number of factors, of course.)
Another major advantage of this strategy is the reduced amount of risk. Since we receive cash every time we sell a call option contract, we are able to insulate our portfolio against a potential decline. There is still risk involved, of course, but we take on significantly less risk than a traditional buy-and-hold investor.
On the negative side of the ledger, the covered call strategy requires more activity on a week-to-week basis. This is especially true if you're looking to generate recurring income from a position.
We typically recommend a four-to-six-week trading window. While it is a far cry from day trading, it is still necessary to monitor positions and enter new positions on a regular basis. This approach takes more time and energy than simply buying a stock and forgetting about it.
Taxes, Taxes, Taxes
From a tax perspective, the higher level of activity can also be problematic. You see, selling covered calls against a position allows you to effectively reduce the cost basis of that position. This can be very helpful if you hold the stock for a long period of time. But the higher level of activity typically generates a significant amount of short-term gains.
Short-term gains are usually taxed at your maximum tax rate. Dividends and long-term gains, on the other hand, are typically taxed at lower rates. While a higher tax rate can be an inconvenience, ideally your gains should more than make up for the additional tax burden.
Still, there are some strategies you can use to manage, or in some cases eliminate, the tax burden of the covered call strategy.
Dual Approaches, Dual Accounts
Let's assume, like most investors, your investment approach embraces a number of different strategies. You love the income generated by the covered call approach. But you also see the merits in holding long-term growth stocks. You're also more than willing to take speculative short-term trades when the opportunity is right.
Many traders hold separate brokerage accounts for different strategies. These could be retirement accounts, education accounts, traditional savings, or investment accounts. If you don't have more than one investment account, maybe you should... Then you'll have to decide which is the most appropriate for a new trading opportunity.
Most investors view their retirement account as a good spot for their more conservative trades. After all, this is likely the account you intend to live off of (or currently do live off of) at the end of your career.
But let's say you have separate taxable and tax-deferred (or tax-exempt) accounts that you use for trading. We encourage you to look at these accounts from a long-term tax perspective. Don't simply sequester the trades based on aggressive or conservative lines.
Think about it this way... You own the entire account. A you fully plan to have both your taxable investment money and your tax-deferred account when you retire, right? So why not focus on allowing them both to grow in the most efficient way?
With this in mind, we suggest using a traditional IRA or a Roth IRA for an active covered call approach. Most IRA custodians allow you to use the covered call strategy in your IRA. And if you have a broker that does not, you need to think about transferring your account anyway.
In the case of a traditional IRA account, you will eventually have to pay taxes on the capital gains. But since this account is long-term in nature, the IRS doesn't distinguish between short-term and long-term gains as far as individual trades are concerned.
Roth IRA accounts are an even better deal from a tax perspective because you pay taxes on your income before putting the money into the retirement account. From that point, the account can grow indefinitely (through long-term gains OR short-term gains) without ever causing you to realize a tax liability.
Bringing It All Together
With this in mind, one approach could be to place trades that are more likely to generate short-term profits in your IRA account. This includes your covered call trades, since you're probably setting up these trades with a four-to-six week time frame.
When you take a position that you expect to hold for a year or more, you could use your traditional taxable brokerage account. This way you're generating your most heavily taxed gains in accounts that are "sheltered" from the IRS. Meanwhile, you're growing your capital from a more tax-friendly perspective in the accounts that will be taxed on a year-by-year basis.
Of course, everyone's situation is different. It's a good idea for you to speak to a qualified tax accountant to make sure these guidelines apply to your own accounts. But as a general rule, using tax-deferred and tax-free accounts for your covered call trades will allow you to keep more of your hard-earned income. This will leave you with a stronger investment portfolio in the long run.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.