Earning high returns is always the goal of selling covered calls, and when you follow our advice and pair VectorVest with OptionsPro, you’ll set yourself up for more profits with less work and stress.

However, the additional income you earn will also increase your tax burden. After all, the government isn’t going to let you make a decent living without taking their slice of the pie. This is why an understanding of the tax implications of covered calls is so important.

Not only can you better prepare yourself by setting aside a portion for taxes on covered calls, but you can also take steps to mitigate your tax burden and avoid paying more than you’re obligated to.

We’ll cover everything you need to know about covered calls taxes below, including the treatment of both premiums and stock sales. You’ll also learn how you can boost your success rate in the options trading realm with our stock analysis software here at VectorVest!

The Basics of Covered Calls

Before we get into the tax side of things it’s worth a quick overview of the strategy itself. So, how do stock options work? More specifically, what is a covered call? This is a unique approach to options trading in which you’ll own a stock and then sell call options on it.

In case you’re not familiar with the difference between a call vs put, this type of option gives the owner of the contract the right – but not the obligation – to buy the stock from you at a predetermined price (known as the strike price in options) before a specified expiration date.

Why would you do this, though? Simple – you can earn supplemental income through premium from selling the contracts while still benefiting from marginal stock price appreciation.

If the stock’s price dips a bit, your premium income will offset the losses to some degree. If the stock price rises a little bit, you earn capital appreciation and premium income. The potential downside to this stock investment strategy is capped income.

If the stock price rises above the strike price the buyer will exercise the option and you’ll have to sell them the stock below market value. While you’ll still earn a profit on the sale of the stock, you’re missing out on additional income – which is why covered calls are bad in some cases.

Still, this is one of the best ways to make money with options in a slightly bullish market or when holding stocks with low volatility. The only question is, how are options taxed?

What are the Tax Implications of Covered Calls?

The tax implications of covered calls can be a bit more complex than with taxes on buying call options. That’s because there are two different pieces of the puzzle – income from premiums and income from stock appreciation/sales.

Tax Treatment of Premiums Received

Premium income is taxed as a short-term capital gain, as the option you’re selling typically has a short-term expiration date. However, the specific tax treatment depends on what happens when options expire.

If the call option expires without being exercised, the premium received is treated as a short-term capital gain. It’s taxed at your ordinary income tax rate, regardless of how long you have held the underlying stock.

On the other hand, the premium received from the sale of the option is added to the sale price of the stock if the option is exercised and you sell the stock at the strike price.

The total amount is then used to calculate your capital gain or loss on the stock. The holding period of the stock determines whether the gain or loss is short-term or long-term.

Tax Implications of Stock Sales

Speaking of stock sales, this aspect of covered calls taxes is unique in its own right. If you’ve held the stock for one year or less, any gain from the sale of the stock is considered short-term and is taxed at your ordinary income tax rate.

But if you’ve held the stock for more than one year, the gain is considered long-term and is taxed at the more favorable long-term capital gains tax rate.

Example of the Taxes on Covered Calls

The tax implications of covered calls can be complex, so let’s break it down with a simple example.

Say you own 100 shares of XYZ stock at $50 per share. You sell a covered call with a strike price of $55 and receive a $200 premium. Here’s how the tax implications could play out:

  1. Option Expires Worthless: The $200 premium is a short-term capital gain. You keep the stock, and the premium is added to your income for the year.
  2. Option is Exercised: You sell the stock at $55 per share. Your sale proceeds are $5,700 ($55 x 100 shares + $200 premium). If you held the stock for more than one year, the gain is long-term. If less than one year, it’s short-term.

Understanding the implications of taxes on covered calls is just the first step. Then, it’s a matter of mitigating your tax burden through carefully executed strategies. We’ll share some tips below.

Tips on Mitigating Taxes on Covered Calls

Just as with swing trading taxes, there are a few ways you can offset the tax implications of covered calls.

Utilizing Tax-Advantaged Accounts

Using one of the different types of retirement investment accounts can be a great way to offset your tax burden. Two of the most common options are Individual Retirement Accounts (IRAs) or Roth IRAs.

By trading within these accounts, the premiums you earn from selling covered calls can grow tax-free or tax-deferred. This means you won’t owe taxes on the gains each year, which can greatly enhance the compounding effect of your investments over time.

Roth IRAs are particularly beneficial because qualified withdrawals in retirement are tax-free, allowing you to keep more of your earnings. You can also learn about the best dividend stocks for Roth IRA in our blog.

However, you’ll have to be aware of the implications of pulling income from these accounts early – you could be subject to early withdrawal penalties. If you’re learning how to sell options for supplemental income in the here and now this strategy may not make sense for you.

Holding Period Strategies

You now know that the g-term capital gains tax rate is much lower than its short-term counterpart. So, you can use this to your advantage to pay less taxes on covered calls – just hold the underlying stocks for more than one year before writing covered calls!

This strategy not only reduces your tax liability but also aligns with a more disciplined, long-term investment approach. If you sell a covered call and the stock is called away before the one-year holding period, you’ll be subject to short-term capital gains taxes.

Offsetting Gains with Losses

Tax-loss harvesting is a unique concept in which you offset the gains from covered calls with losses from other investments. You can sell losing positions and count those losses towards your gains, thereby reducing your overall taxable income.

It’s important to be aware of the “wash sale” rule, which disallows a loss deduction if you buy a substantially identical stock or security within 30 days before or after the sale. Properly timing is essential to maximize this strategy’s benefits.

Consulting with a Tax Professional

The best way to navigate covered calls taxes is with the help of an expert. Tax laws and regulations can be complex and frequently change, after all.

A tax advisor can provide personalized advice based on your specific financial situation and investment goals, helping you navigate the complexities of the tax code and identify opportunities for tax savings that you might not be aware of.

More Advice on Successfully Executing a Covered Call Strategy

While we may not be tax professionals, we can help you earn higher returns by executing a consistent covered call strategy. Just be aware – following our advice below will raise your tax burden as you’ll earn more profits!

Choosing the Right Stocks

The first step to successfully selling covered calls is picking the right stocks. The goal is to find opportunities that are relatively stable and have high liquidity. They’re less likely to drop significantly, which helps manage risk, while liquidity ensures you’ll find a willing buyer.

We suggest companies with a strong track record of stable earnings and consistent dividends are often good candidates. Sector stability is also important. Utilities and consumer staples are typically less volatile than technology or biotech sectors

You can read through our list of the best dividend stocks, or get more specific and filter through our lists of the top high dividend stocks, safest dividend stocks, or the best blue chip stocks with dividends.

We also have a great list of the best stocks for covered calls 2024 to point you in the right direction. But, you’re better off leveraging the best stock picker to consistently uncover these opportunities on autopilot – more on that later.

Setting the Strike Price and Expiration Date

Proper risk management options trading involves balancing the desire for premium income with more favorable strike prices and expiration dates.

The goal is to earn as much income as possible while still ensuring these factors are in your favor so the contract remains out of the money (OTM).

The strike price should be set above the current market price to allow for some capital appreciation. However, setting it too high might result in the option not being exercised, and thus you might only collect the premium without selling the stock.

The expiration date should align with your investment goals and market outlook. Shorter-term options tend to have higher premiums but require more frequent management. Longer-term options provide stability but offer lower premiums. Think about the taxes on covered calls as well.

Evaluating the stock’s historical volatility and upcoming events (like earnings reports) can help you make more informed decisions. Better yet, eliminate any uncertainty by creating your options contracts with the help of VectorVest and OptionsPro.

Let VectorVest and OptionsPro Do the Heavy Lifting to Help You Earn Higher Returns With Less Work!

Understanding the importance of how to find good options trades consistently along with skewing the strike price and expiration dates in your favor, it’s worth setting yourself up for success with the best stock analysis app: VectorVest.

Our stock advisory helps you uncover winning opportunities on autopilot through a proprietary stock rating system. It tells you what to buy, when to buy it, and when to sell it all at a glance, saving you time and stress.

Once you have a list of stocks you can use OptionsPro to configure the strike price and expiration dates in your favor with a suite of tools, including high-probability candlestick patterns, volatility indicators, Probability Envelopes, specialized theta decay charts, and more.

This dynamic duo will help you sell better covered calls, earning more premium income without being forced to fulfill the obligation of selling your stocks.

VectorVest is the best investment app for beginner traders and expert investors alike. It can be used for other investment strategies like building a stock portfolio for retirement or swing trading strategies, too.

But don’t just take our word for it. Get a free stock analysis and discover firsthand how much easier and less stressful profitable investing can be!

Closing Thoughts on Covered Calls Taxes

Understanding the tax implications of covered calls is essential for maximizing the benefits of this strategy. While there are quite a few moving pieces – from premium income to stock sales, short vs long-term capital gains, and more – we hope to have cleared the air for you.

Be sure to put our strategies for offsetting covered calls taxes to the test to help you protect as much of your profit as possible from the tax man. Utilize tax advantaged accounts and strategic holding periods to shield your returns.

Continue to learn stock options trading in our blog, with tips on swing trading options, options open interest, what does it mean to exercise stock options, warrants vs options, IV in options trading, trading futures vs options, the benefits of trading stock options, and more.

From the best stock apps for iPhone to the best stock apps for Android, you won’t find a more comprehensive solution than VectorVest. It has outperformed the S&P 500 index by 10x over the past 20 years and counting, and pairing it with OptionsPro is a match made in heaven for anyone interested in selling covered calls.

So, take the stress and guesswork out of options trading today and set yourself up for smooth, successful investing – just be prepared to pay more taxes on covered calls when using VectorVest since your returns will rise!