• Skip to primary navigation
  • Skip to main content
  • Skip to footer
Exceed Investments

Exceed Investments

Let us be your Options Expert

  • Why Exceed
  • Strategy Spotlight
  • Who We Are
  • Blog
  • Contact
  • Login

taxstrategy

The Power of Using Options in Retirement Accounts

At first glance, you might be thinking I’m insane to even be mentioning options and retirement accounts in the same breath. After all, options are meant for rampant speculation and are super risky, right? While they can be used for “gambling” purposes if so desired, options are flexible instruments that have a wide variety of uses and benefits, even in qualified retirement accounts such as an IRA.

The main benefit of investing in an IRA is that taxes are either deferred until the money is withdrawn (traditional IRA), or the account can be funded with after-tax dollars and grow over time without accruing any tax liability (Roth IRA). I won’t get into the details too much here, but Roth IRAs generally aren’t available to high-income households, though there are some workarounds. What’s important to note is the potential power of tax deferral and the effect that it can have on a retirement portfolio. This benefit is amplified when using an income-generating strategy such as writing covered calls against existing stock holdings.

Consider a hypothetical portfolio of $100,000 that’s fully invested in equities. Let’s assume, to illustrate the math, that this portfolio returns 8% every year for 30 years, there are no annual contributions, and the investor implements a covered-call overlay strategy that generates an additional 3% annually in yield. The yield-generating potential of each portfolio depends on the volatility of its holdings, but we think 3% annual yield via covered calls is a conservative assumption. We’ll also assume that this investor is married and sits in the 22% tax bracket, which indicates a total household income range of $89,450 to $190,750 for 2023. For simplicity’s sake, we’ll also assume that no stock holdings are sold at any point until the end of this 30-year period. Lots of unrealistic assumptions here-especially the lack of volatility, which is obviously significant in the real world-but the simplicity helps make the point about the effect of taxes, since that’s the only factor that differs in the three scenarios shown.  Here’s what the growth of this hypothetical portfolio would look like over time. The “Portfolio value” column is a beginning of year number.

Profits from covered calls are taxed as capital gains, and in this example the tax rate is 22%. This tax liability is subtracted from the portfolio value every year and is a drag on the effects of compounding. The stock gain at the end of this 30-year period is taxed at 15%, the long-term capital gains rate for married couples earning $89,251-$553,850 annually. While this hypothetical investor accumulated significant wealth over this period, the taxes due each year from the covered-call returns were a drag on total returns.

Now let’s look at the numbers had this $100,000 originally been held in a traditional IRA. The assumptions remain the same as the example above in the taxable account, but the tax treatment is different. In a traditional IRA, all taxes owed are deferred until retirement, which we’re assuming is in 30 years. The tax rate on all gains in a traditional IRA is the income tax bracket that the investor resides in, which in this case is 22%. Both the stock and dividend profits will be taxed at 22%, but not until the end of this thirty-year period.

The deferred tax treatment in this case led to an additional net return of 0.22% annually. While this doesn’t seem like much on the surface, this can be significant over 30 years. In this example, that equated to an additional $103,936 in portfolio value! This amount would be even greater over a longer time horizon, or if the assumed returns were higher.

Lastly, let’s look at the numbers if this hypothetical portfolio was in a Roth IRA. Roth IRAs allow for all gains to grow tax free. The drawback to Roths is that there are annual contribution limits, income requirements, and if you roll an existing retirement account into a Roth IRA, you’ll likely owe income taxes on that money at inception. Most retirement accounts are funded with pretax dollars whereas a Roth IRA is funded with post-tax dollars. However, once this one-time tax is paid, you’ll never have to pay another penny in taxes on that account, assuming the appropriate rules are followed.

As you can see, the effect of not having to pay annual or terminal taxes on this account is substantial. An additional 0.87% net return annually (via tax savings) from a Roth IRA versus a traditional IRA equated to $481,631 more in portfolio value at the end of this period. This is a great example of how being tax savvy at the margin can have a dramatic effect on wealth as time goes on.

Retirement accounts aren’t generally where you see option activity, but small return enhancements over time can really add up. Using a covered-call overlay strategy inside of a tax-advantaged account can reduce volatility, potentially increase returns on both an absolute and risk-adjusted basis, and have a significant effect on retirement wealth.

 

 

IMPORTANT DISCLOSURE: The information in this blog is intended to be educational and does not constitute investment advice. Exceed Advisory offers investment advice only after entering into an advisory agreement and only after obtaining detailed information about the client’s individual needs and objectives. No strategy can prevent all losses or guarantee positive returns. Options trading involves risk and does not guarantee any specific return or provide a guarantee against loss. Clients must be approved for options trading at the custodian holding their assets, and not all retirement accounts are permitted to trade options. Transaction costs and advisory fees apply to all solutions implemented through Exceed and will reduce returns.

You Made a Fortune in One Investment. Now What?

The Pareto Principle states that roughly 80% of consequences come from 20% of the inputs. This concept was developed by economist Vilfredo Pareto in the 1800s and has multiple applications in business, including management, marketing strategy, customer service, and investing. In the finance world, application of this principle lends itself to the theory that the vast majority of an investor’s gains come from a small percentage of their total investments, while most of their portfolio will underperform the broad market over long time horizons.

Many investors find themselves in the enviable predicament of having too much exposure to one or a few companies because of their outperformance versus the market. A theoretical buy-and-hold investor who bought a big position in Apple (AAPL) 10+ years ago would be a good example of this. Yes, the rest of their portfolio has likely appreciated over that timeframe, but AAPL has far outpaced the market. As a result, a large portion of this person’s wealth is now tied to one company. Other examples of this phenomenon include employees of a company who have accumulated significant wealth via stock options and others who have inherited sizeable stock positions. Holding such positions dramatically increases risk and leaves them vulnerable to significant drawdowns. Numerous studies have shown that portfolios with concentrated positions are destined to underperform – it’s only a matter of time. 1Baird’s Private Wealth Management Research, “The Hidden Cost of Holding a Concentrated Position. Why diversification can help to protect wealth.” https://www.bairdwealth.com/siteassets/pdfs/hidden-cost-holding-concentrated-position.pdf 2Nathan Sosner, “When Fortune Doesn’t Favor the Bold. Perils of Volatility for Wealth Growth and Preservation. ”The Journal of Wealth Management Winter 2022, jwm.2022.1.189; DOI: https://doi.org/10.3905/jwm.2022.1.189

Someone looking to rebalance into a diversified market portfolio has to make the important choice of how to reallocate their funds. There are generally four options: 1) Sell the shares and take a big hit to the portfolio value via capital gains taxes, 2) Use traditional tax-loss harvesting methods and sell some losing positions to offset the gains in their concentrated position, 3) Transfer their position into an exchange fund, or 4) Use option overlays to mitigate or eliminate tax liability. Let’s take a look at each of these methods.

An outright sale of the shares is by far the most punitive of the above choices. Federal long-term capital gains tax rates in 2023 are 15% for married couples earning over $83k per year and reach 20% for those earning more than $553k annually. Additionally, 42 of 50 states tax capital gains as income and the tax rates range from 2.9% to 13.3%, with most landing in the mid-single digits.  Selling the shares outright can be viewed as an immediate loss of 15-25% of that position’s value, and the tax bill can be significant in many situations. Limiting such liabilities is obviously optimal for long-term wealth appreciation.

Traditional tax-loss harvesting is a very popular method employed by wealth managers, but it has its shortcomings. Generally applied near the end of the year, advisors will look to rebalance their client portfolios and avoid taxes due by selling both losing and winning positions. If you can accrue losses equal to the amount of gains that have been booked, then the effective tax liability is zero. However, this requires that the client actually has significant paper losses that can be harvested. The end of 2022 was a very popular time for this method because of the large number of companies that experienced significant declines, but loss harvesting won’t always be a viable option. This flies in the face of the traditional methodology of “buy low, sell high,” as you’re selling both losing and winning positions. Lastly, wash sale rules require that the investor can’t buy the position back for 30 days after it’s sold.

Exchange funds have become popular vehicles for tax optimization among ultra-high-net-worth individuals. An investor looking to reduce a concentrated position can move it into an exchange fund, which is basically a pool of other concentrated positions that have been aggregated by an asset manager. The investor is “exchanging” their holding in one or a few positions for a pro-rata allocation of the pool of assets. This diversifies their portfolio, reduces risk, and allows the holder of one or a few stocks to now own a percentage of the fund without having to sell their concentrated holding and pay capital gains taxes. While this may sound like the perfect solution for concentration issues, exchange funds have their problems. Most have a minimum position size of $5M, which effectively eliminates this option for a huge percentage of investors. For those able to meet the minimum asset requirement, entering into an exchange fund requires a seven-year commitment. Any asset sales before the end of this lockup period will result in penalties due to the fund, and in some instances the fund will just transfer the original concentrated position back to the investor. For anyone who may have short-term liquidity needs over the next seven years, this makes such a time commitment a difficult proposition. Lastly, exchange funds can be expensive, with many charging a management fee of 150-200 basis points annually. Despite these shortcomings, exchange funds can still make sense for some individuals who have significant tax liabilities and low liquidity needs.

Option overlays are the final (and in our biased opinion, best) solution for mitigating tax liability and concentration issues. An investor holding a large position in one company can use covered calls or collars as tools to reduce volatility, generate yield, and in many instances completely eliminate tax liability over time. The strategies offer a great deal of flexibility and can be tailored to meet the specific needs of each individual investor. An option overlay program can be either systematic or tactical, which can create the potential for excess alpha generation and isn’t a drain on liquidity. Depending on volume and transaction size, the costs to implement these programs are often minimal when compared to those of an exchange fund. The use of options will require the investor to pay commissions to their broker, and of course there are management fees assessed. However, in many cases, the total cost to the investor may be significantly less than the price of other solutions.  The cost is also usually minimal when compared to the tax savings that can be realized. Most option overlay strategies can be implemented for 50 basis points annually or less, and this cost is oftentimes only a small fraction of the total tax liability.

Options provide a value-add to an advisory practice and its clients, but they can be complex. Additionally, the tax code is difficult to navigate and these overlays will require constant attention and rebalancing. The team at Exceed Investments has over 40 years of professional derivatives experience and can streamline this process for you and your clients, allowing them to efficiently grow their wealth.

Contact us for a consultation.

 

 

This blog post is for informational or educational purposes only and is not intended as investment advice.  Any discussion of investment strategy or approach is intended only to illustrate investment concepts and in no case does the discussion represent Exceed Advisory’s investment performance or the results of any Exceed Advisory portfolio.  We provide investment advice only to clients and only after entering into an advisory agreement and obtaining information concerning individual needs and objectives. We think the information provided is accurate, but accuracy is not guaranteed. All investing in securities involves risks, including the risk of loss.

Footer

Get in Touch

  • 79 Madison Avenue 3rd floor,
    New York, NY 10016
  • 646-580-7046

Legal

  • Privacy Policy
  • Terms and Conditions
  • Disclosures

Recent Posts

  • Overlay Economics: Evaluating the True Cost (and Value) of Options Strategies – Featuring NVDA
  • The Psychology of Concentrated Positions: Helping Clients Take Action Through Structure
  • Common Misconceptions About Option Strategies: What Advisors Need to Know

Copyright © 2025 · Exceed Investments · Web Design Services by JSMT Media