Understanding Tax Benefits of Broad-Based Index Options

I’ve developed a meaningful pet peeve over the past few years. I take issue with the ubiquitous response, “100%.” It’s pervasive and it annoys me! Apologies in advance if you hadn’t picked up on the “trend” in language because you’ll notice it all the time.

Perhaps it’s a sign of my aging. Maybe it’s the fact that I’ve worked in derivative markets for 25 years and I’ve lived through plenty of “unimaginable” events. Or is it just that I admire Ben Franklin’s practical point of view upon finishing the Constitution:

“Our new Constitution is now established and has an appearance that promises permanency; but in the world nothing can be said to be certain, except death and taxes.”

I’m certain my life will end at some point because that’s how it’s worked for each of the roughly 117 billion people that have roamed the earth. We have a gigantic sample size and every one of them died. That is 100% in my book.

I’m also positive that I’m going to pay taxes. That’s how we’ve structured modern society. By definition, a tax is “a compulsory financial charge or levy imposed by an organization to collectively fund public expenditures and reduce negative externalities.”

I’ve met a lot of people in my (nearly) 47 years and every one of them has paid taxes at some point. Another sizeable sample size and same outcome in every case. That too is 100% in my book.

In short, I think Ben Franklin was right. These days, we remember the “death and taxes” portion, but overlook the “in the world nothing (else) can be said to be certain.”

Next time you’re tempted to respond “100%,” maybe consider an alternative.

• “I absolutely agree!”
• “What a great point!”
• “That’s a very likely outcome, statistically speaking it’s in the 90 plus percentile.”

Your friends might get annoyed, but unlikely outcomes occur far more frequently than we care to admit. Respect the odds.

Taxing Time

In the next few weeks, you may also have conversations about the upcoming tax deadline. For most taxpayers, Monday April 15, 2024 is the deadline for filing returns, paying any tax owed, or requesting an extension. This can be a stressful period for taxpayers and accountants.

The 16^th Amendment, which allowed the Federal Government to levy income taxes, was originally about 30 words in total. It’s grown to about 35 million words. To give that a bit more context, the longest book written in English is Clarissa. or, The History of a Young Lady (Volume 1). Samuel Richardson’s epic has a word count of ~943,000. So, the tax code is about 37 times longer than the most loquacious English language book.

Reagan Revolution

Back in the early 1980s, the derivatives world was a niche marketplace. The equity and fixed income markets were much more mature by comparison. The first cash-settled futures contract (Eurodollars) started trading in 1981. The following year, the Chicago Mercantile Exchange (CME) introduced stock index futures. In early March of 1983, the first cash-settled index option product also began trading in Chicago.

These innovations spawned a growing ecosystem around equity indexes and other important financial markets. Dan Rostenkowski was a congressman from the state of Illinois, whose district included headquarters for the CME, Chicago Board of Trade (CBOT), and Chicago Board Options Exchange (CBOE).

By the 1980s, Rostenkowski rose to serve as Chairman of the Ways and Means Committee. That was a powerful role, and he was able to influence the tax overhaul bill during the first Reagan administration. To help support his constituents and growth in the derivatives markets, Rostenkowski carved out section 1256 contracts.

You can read about the potential tax benefits of broad-based index options (and a handful of other derivative products) on the IRS’ website.  

Not Advice

The following information does not constitute tax advice. The tax code has become complex and taxes are a personal or family matter. I’ve used broad-based index options for years. I also use equity/ETF options as well as holding some underlying securities. I work with a Certified Public Accountant (CPA) who understands the nuance of tax law. In my experience, there can be material benefits from using “1256 Contracts.”

Generally speaking, the gains/losses from equity/ETF options (held for less than 365 days) are taxed at your marginal income rate, which varies depending on your taxable income. For most taxpayers, the rate is somewhere between 22% and 37%. For the sake of example, let’s assume that a market participant falls in the 32% tax bracket and they accrued gains of $10,000 from the use of equity/ETF options during the 2023 calendar year. Let’s assume that all the options were held for less than 365 days.

Those gains would likely be taxed at their short-term rate (32%). So, the $10,000 in profits becomes ~$6,800 in after tax gains.

• $10,000 * 0.32 = $3,200 hypothetical tax liability.

By contrast, broad-based index options are typically taxed differently. 1256 contracts often qualify for a 60%/40% treatment where 60% of the gains are taxed at the long-term rate (lower) and 40% are taxed at the short-term rate (higher).

Using the same assumption about gains in calendar year 2023 and marginal tax bracket (32%), but switching from equity/ETF options to $10,000 in gains all from broad-based index options, the tax implication could look like this:

• $10,000 * 0.60 = $6,000 taxed at long term rate (between 0% and 20% depending on income)
• In this case, we’ll assume a 15% long-term rate, so $6,000 * 0.15 = $900 (tax liability)
• $4,000 is taxed at the marginal rate of 32%, so $4,000 * 0.32 = $1,280
• Hypothetical total tax liability = $900 + $1,280 = $2,180

This works out to a blended/effective tax rate of ~21.8% for the user of broad-based index options. The market participant with all gains coming from equity/ETF options incurred a 32% tax rate. The difference can be stark.

Broad-based index options can qualify for preferential treatment independent of the holding period. In other words, the gains could be realized in 1 day or 364 days. In the case of equity/ETF (option) products, they must be held for more than 365 days to qualify for the long-term tax rate.

Consider Your Alternatives

Potential tax benefits are one consideration when choosing derivative products. At the individual level, the calculus is broader. If you manage primarily single stock/equity positions with options, you may not change much based on the IRS tax code. However, if you actively trade ETF options that are designed to track a broad-based index, there may be a compelling catalyst, particularly given the smaller notional products that have been introduced in recent years.

Let’s use the Nasdaq-100® Index (NDX) as an example.

There are a handful of ETFs designed to track the Nasdaq-100. They include:

• QQQ
• QQQM

There are variations as well. For example, there are ETFs that give “equal weight” exposure to the constituents in the NDX.

If you manage a portfolio with a core position in an NDX tracking ETF, you might consider using Nasdaq-100 Index Options (NDX) or Nasdaq-100 Micro Index Options (XND) options to customize your exposure. They are considered “broad-based index options” which may qualify for preferential tax treatment.

As Benjamin Franklin opined around 1789 – death and taxes are inevitable.

Nearly a century later, Dan Rostenkowski and the Congress of the 1980s added a bit of wrinkle. Death and taxes remain a certainty, but the effective tax rate may be improved depending on the products you choose.

You can find much more information from brokerage firms and tax providers.

This column is written for educational purposes only and does not constitute tax advice. For formal guidance on the tax implications of owning index options, consult a tax professional.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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