Section 1256 and the 60/40 Rule

Two funds can both sell options on the S&P 500 and pay similar distributions, yet leave taxable investors with noticeably different amounts after tax. A big reason is a corner of the tax code called Section 1256. It sounds obscure, but if you hold option income funds in a taxable account, it’s worth understanding.

What a Section 1256 contract is

Section 1256 of the Internal Revenue Code gives special tax treatment to certain contracts, including regulated futures and options on broad-based stock indexes. The key distinction for income investors:

SPX options and SPY options move almost identically, but they’re taxed completely differently. Index options are also cash settled and European style, so no shares ever change hands and they can’t be exercised early.

The 60/40 rule

Gains and losses on Section 1256 contracts are treated as 60% long-term and 40% short-term, no matter how long you held them. An option sold and closed within a week gets the same split as one held for years.

At the very top brackets the blended rate works out to 26.8%, against 37% for ordinary short-term gains. Try your own numbers:

Two more rules: mark to market and loss carryback

• Mark to market. Open Section 1256 positions are treated as sold at their market value on December 31, so you’re taxed on unrealized gains each year and can deduct unrealized losses.
• Loss carryback. Individuals with a net Section 1256 loss can elect to carry it back up to three years against earlier Section 1256 gains, something most capital losses can’t do.

If you trade index options yourself, these show up on Form 6781. If you own a fund that does, the fund deals with them.

How it reaches you through a fund

An ETF that sells index options gets the 60/40 treatment on its own gains. It then passes its results to you through its distributions, which are classified as ordinary dividends, capital gain distributions or return of capital. Two things decide how favorable that turns out:

1. What the fund sells. Index options qualify; ETF options and equity linked notes don’t. Funds that sell SPX or NDX options, such as SPYI, QQQI, and also QYLD and XYLD, get 60/40 treatment on their option gains. Funds whose income comes from notes, like JEPI, generally pass it on as ordinary income.
2. How actively it manages taxes. Some managers, notably NEOS with SPYI and QQQI, deliberately realize losses on the stocks and options they hold to offset gains. That’s why a large share of their distributions has often been classified as return of capital, deferring the tax further.

The limits

• Only matters in taxable accounts. In an IRA or 401(k), 1256 treatment makes no difference.
• Tax is one factor. A fund that saves you 1% a year in tax but trails another by 3% a year in total return isn’t a better deal. Compare after-tax total return.
• Classifications vary year to year. A fund’s mix of ROC, gains and income changes with markets. Check its year-end tax notice rather than assuming.
• Rules change. Tax treatment depends on current law, which Congress can change.