The Most Tax-Efficient Way to Use Covered Calls

The covered call strategy has some very strong advantages and a few drawbacks as well.

On the positive side of the ledger, this strategy has the ability to generate attractive and reliable returns on a monthly basis. As a general rule, I like to set up trades that can book between 25% and 35% per year on a consistent basis.

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 in the stock. There is still risk involved in the strategy, 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. While it is a far cry from day trading (we typically hold our positions for a four-to-six-week period), it is still necessary to monitor positions and to enter new positions on a regular basis. This approach takes more time and energy than simply buying a stock and forgetting about it until retirement.

From a tax perspective, the higher level of activity can also be problematic. You see, while selling covered calls against a position can allow you to reduce the cost basis of that position, which can be very helpful if you hold the stock for a long period of time, 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, whereas dividends and long-term gains are typically taxed at lower rates. While a higher tax rate can be an inconvenience, remember that our attractive gains (targeted at 25% to 35% per year) should more than make up for the additional tax burden.

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Still, there are some strategies that you can use to manage, or in some cases eliminate, the tax burden of the covered call strategy.

Dual Approaches, Dual Accounts

If you’re like me, your investment approach embraces a number of different strategies. While I love the income generated by the covered call approach, I also see the merits in holding long-term growth stocks, and I am more than willing to take speculative short-term trades when the opportunity is right.

Many traders hold separate brokerage accounts for retirement accounts, education accounts, traditional savings and investment accounts. If you have more than one investment account, you typically 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 if you have separate taxable and tax-deferred (or tax-exempt) accounts that you use for trading, I want to encourage you to look at these accounts from a long-term tax perspective, and not simply sequester the trades based on aggressive or conservative lines. Since you own the entire account and will have both your taxable investment money and your tax-deferred account when you retire, why not focus on allowing them both to grow in the most efficient way?

With this in mind, I would suggest using a traditional IRA or a Roth IRA for your 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 in your account. 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.

For my accounts, I prefer to place trades that are more likely to generate short-term profits in my IRA account. This includes my covered call trades because I typically set these trades up with a four-to-six week time frame.

When I take a position that I expect to hold for a year or more (or when I trade futures or forex contracts, which have a built-in tax advantage), I use my traditional taxable brokerage account. This way I am generating my most heavily taxed gains in accounts that are “sheltered” from the IRS, while growing my 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, and it is a good idea for you to speak to a qualified tax accountant to make sure that 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 — leaving you with a stronger investment portfolio in the long run.