Return of Capital: The Part of Your Dividend That Isn't Taxed

A fund pays you 12%. You pay tax on 12%. That is what most people assume, and for many funds it is wrong — badly wrong. On some of the highest-yielding ETFs, almost none of the distribution is taxable in the year you receive it.

The mechanism is called return of capital, and it is the single most consequential thing about income ETFs that nobody explains.

When a fund sends you money, that money falls into one of two buckets.

Ordinary income is what you expect: dividends from the stocks the fund holds, plus — for option-based funds — the premium collected from selling calls. It is taxed the year you receive it, at your marginal rate. Up to 37% federally, plus state.

Return of capital is different in kind. It is not income at all; it is your own money coming back to you. The fund is returning a portion of your investment rather than distributing earnings.

Because it is not income, it is not taxed on receipt. Instead it reduces your cost basis — the amount you paid — which means your eventual capital gain is larger when you sell.

Return of capital is a deferral, not a forgiveness. That sentence is the whole article, and it is where most explanations stop short. The tax is not avoided; it is moved.

This is not a corner case affecting obscure funds. Taking the distribution records of the largest income ETFs and separating the two categories:

JEPI and QQQI both advertise yields around 8% and 14% respectively, and both generate their income by selling options. Structurally they could hardly be more different.

The classifications above come from the funds’ own distribution records and line up with the return-of-capital percentages on their 1099s. You can see the live figures on the Dividend ETF Calculator, which derives them from the distribution history rather than from a static database.

The difference comes from how the option income is generated.

JEPI gets its option exposure through equity-linked notes — contracts written by counterparty banks. The premium that flows through those notes is treated as ordinary income. There is no mechanism to characterise it otherwise.

QQQI and SPYI write options directly on broad indices — SPX and NDX. Those are Section 1256 contracts, which receive a special tax treatment: gains are taxed at a blended 60% long-term / 40% short-term rate regardless of how long the position was held. NEOS layers tax-loss harvesting on top, and the result is that most of the distribution is characterised as return of capital.

Both approaches are legitimate. They simply land your money in different places on the tax form.

Here is the part that catches people out. Return of capital reduces your cost basis, and if it reduces it all the way to zero, the excess becomes taxable gain immediately.

A simple illustration. You buy $100,000 of QQQI. Over ten years at a 14% distribution rate with 95% classified as return of capital, roughly $133,000 comes back to you untaxed — but your cost basis does not go to zero, it goes to zero and then keeps going in the sense that everything past the original $100,000 is treated as gain in the year the basis is exhausted.

In practice this takes many years at realistic distribution rates, and it means the eventual tax bill is at long-term capital gains rates rather than ordinary rates — still better, but not free.

There is also a record-keeping burden. You have to track your adjusted basis over time, and your broker reports it on the 1099-B when you sell. It is not complicated, but it is not something you can ignore until April.

This is where the distinction becomes actionable, and where the common mistake lives.

In a taxable account, return of capital has real value. The deferral pushes the tax into the future, and when it arrives it is at long-term capital gains rates — 20% at the top end against 37% for ordinary income. That is a large spread.

In an IRA or Roth, the distinction evaporates. Withdrawals are taxed as ordinary income regardless (or not at all, in a Roth), so the Section 1256 advantage disappears. There, the choice comes down to gross distribution and total return.

Which gives the rule that gets stated most often in this corner of the market: high-yield funds that distribute ordinary income belong in a sheltered account, and those that distribute return of capital belong in a taxable one.

Getting it the wrong way round is not a catastrophe, but it is an annual, compounding drag for which there is no compensation.

Before buying any high-yield ETF, find out what its distributions are made of. The fund publishes this — look for the Section 19(a) notices, the annual report, or the return of capital percentage on a 1099 after your first year of holding it.

If a fund markets itself on yield alone and does not make the characterisation easy to find, that is itself information.