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Suppose you want $14,000 of cash a year from a $100,000 stock position, and you are at the top California rates. Three ways to get it, three tax bills.
| Route to $14,000 of cash | Tax this year | Tax deferred to sale |
|---|---|---|
| Sell index-ETF shares with a 40% embedded gain | $1,960 (35% on the $5,600 gain) | $0 |
| Return-of-capital income fund | about $0 | $4,900 (35% on all $14,000) |
| Ordinary-income covered-call fund | $7,280 (52% on all $14,000) | $0 |
The index route also keeps the index return; the two funds give up 4 to 11 points a year of it, the subject of the next read.
Why selling shares wins
When you sell shares, only the gain portion is taxed. On a position that has risen 40%, that is 40 cents of every dollar raised, taxed at 35%, so 14 cents. The other 86% of the position stays invested at the index return, and its appreciation stays deferred exactly as it was.
An income fund pays you the whole $14,000 as a distribution. Either all of it is taxed now, at ordinary rates in the funds built on structured notes, or all of it reduces your basis and is taxed at 35% when you sell. Either way the tax base is the full payout, not the gain inside it. And the fund gives up 4 to 11 points a year of return to generate the payout.
The one case where the fund’s deferral wins
If the embedded gain in your shares is close to 100% of their value, selling shares taxes almost the whole amount anyway, and the return-of-capital route defers it instead. That describes a very old, very low-basis position. It does not describe new money, and the return gap still applies every year on the whole holding.
What a long drawdown does to the payout is unknown
Whether you want the covered-call return pattern for its own sake, which is an investment question, not a tax one. And what happens to a return-of-capital fund’s payouts in a long drawdown, when premium may not cover the target and the fund pays out its own share price; the newest funds have not been through one.