Covered calls can
sound like a smart way to generate income. After all, why not collect option premiums while holding a stock you already own?
But in taxable (non-retirement) accounts, that income often comes with an invisible drag — and it can quietly erode long-term returns.
How Covered Calls Are Taxed
When you sell a covered call, the option premium you receive is typically short-term capital gain. That means it’s taxed at ordinary income rates — not the more favorable long-term capital gains rates — regardless of how long you’ve held the stock.
If the stock is called away, the premium you received adjusts your sale price, often accelerating a taxable event that could have been deferred. And if the option expires worthless, the premium remains fully taxable in the year received.
Why It Creates “Tax Drag”
The appeal of covered calls is the steady stream of income — but that income isn’t tax-efficient. Over time, those short-term gains add up, creating what’s known as a tax drag — a reduction in total return caused by frequent, taxable gains.
For high-income investors, this can mean paying up to 40%+ combined federal and state tax on those option premiums. Meanwhile, the lost opportunity for tax-deferred compounding can be significant compared to simply holding and letting long-term capital gains grow.
When It Can Still Make Sense
Covered calls are best utilized inside retirement accounts, where taxes aren’t triggered until withdrawal. In this case, it simply becomes a way to increase yield on a portfolio of stocks.
In taxable accounts, they also have a role for highly concentrated positions (Procter & Gamble stock is a frequent use case here) where the goal is to generate cash flow in retirement. Traditionally, this is done in the early years of retirement if selling the stock is less than ideal (be it due to stock price, or a desire to hold the stock until death). There is a natural decrease in the range of outcomes when a covered call is used, regardless of the taxation of the strategy.
The Takeaway
Don’t let the allure of “income” blind you to the
after-tax reality.
In many cases, the real return from covered calls — once taxes are factored in — is far lower than it appears on paper.
