How does Return of Capital (ROC) work for YieldMax ETFs like MSTY and ULTY?
Discover how a high rate of Return of Capital for YieldMax ETFs actually provides benefit for investors even though it's often mislabeled as a red flag.
One of the most heated debates for YieldMax ETFs like MSTY 0.00%↑, ULTY 0.00%↑, TSLY 0.00%↑, and CONY 0.00%↑ centers around where the money for the high distributions comes from. Are they actually providing investors incremental income or just re-paying them the capital they originally invested?
TL;DR
Return of Capital (ROC) is a common yet often misunderstood component of ETF distributions — especially for high income ETFs (MSTY, ULTY, TSLY, CONY, and others). Unlike typical dividend income, ROC is a tax classification rather than an indicator of fund performance. It plays a unique role in how ETF investors receive and report income.
What is Return of Capital (ROC)? A Tax Event, Not a Performance Measure
When an ETF pays out distributions, those payments can be classified in several ways, including ordinary dividends, qualified dividends, capital gains, or return of capital. ROC is simply how a distribution is categorized for tax purposes. It does not reflect whether the fund is performing well or poorly.
The core idea: ROC payments reduce your cost basis in the investment, but they are not immediately taxable. Instead, they may impact the taxes you pay when you eventually sell the investment.
How ROC Works: A Simple Example
YieldMax has provided a simple example where an investor buys 100 shares of an ETF at $50 per share, for a total investment of $5,000.
By year-end, the ETF pays out $8 per share in total distributions ($800 total). 38% of the distribution is ordinary dividends while the other 62% is return of capital.
Reminder: For high income ETFs, these distributions are largely generated by the premium collected by selling options using various options strategies:
Distribution breakdown:
Ordinary Dividends: $300 (38% of the distribution)
Return of Capital: $500 (62% of the distribution)
The investor:
Pays tax on the $300 of dividends.
Does not pay tax immediately on the $500 ROC.
Instead, the investor’s cost basis is reduced by the ROC amount, from $5,000 to $4,500.
If the investor later sells the ETF for a gain, that gain is calculated against the lower, adjusted cost basis.
If the investor holds the ETF for more than one year, any gains are typically taxed as long-term capital gains.
Here’s another example from YieldMax: https://www.youtube.com/clip/UgkxPUY-HnMUk32k-VQSDI0dmcblP2J6BY2N
Key Takeaways About ROC
ROC is not a signal of fund performance or a sign that an ETF is losing money.
NAV erosion is not the same thing as ROC — this is often misunderstood. An ETFs NAV can drop for many reasons without ROC being the primary factor. Erosion tends to occur overtime when the total return (gains + distributions) lag in performance compared to the underlying asset.
ROC provides tax deferral by reducing your cost basis now but potentially increasing capital gains later.
ROC is not immediately taxable income.
ETF distributions that include ROC may still be a healthy, strategic part of the fund’s payout approach.
Long-Term Effects of ROC: When Cost Basis Hits Zero
If ROC distributions continue over a long period, an investor’s cost basis could eventually be reduced to zero.
Once the cost basis reaches zero:
Any further ROC distributions are fully taxable as capital gains.
This is an important long-term consideration, especially for investors who focus heavily on high-yield ETFs.
Tax Timing: The ROC Estimate vs. the Final Classification
When ETFs announce distributions throughout the year, they often provide an initial estimate of how much is considered ROC. However, this number is not final.
The actual tax breakdown is confirmed after the end of the calendar year when investors receive their 1099-DIV forms.
Only the 1099-DIV should be used when filing taxes.
Special Situations: Inheritance and Charitable Giving
Step-Up in Basis (Inheritance)
If ETF shares with prior ROC distributions are inherited, the cost basis typically resets to the market value on the date of death. This step-up effectively wipes out the ROC cost basis adjustments for the beneficiary.
Charitable Donations
If ETF shares are donated to a qualified charity, the investor may receive a tax deduction based on the fair market value, not the cost basis. This neutralizes the ROC impact and can make charitable giving an efficient tax strategy.
Benefits of Return of Capital
Tax-Deferred Income: ROC provides cash flow without immediate tax liability.
Potential for Lower Effective Taxes: Gains may qualify for favorable long-term capital gains tax rates.
Portfolio Flexibility: ROC can offer investors a way to manage tax timing strategically.
Risks and Considerations of Return of Capital
Reduced Cost Basis: While tax-deferred, ROC lowers your cost basis, which may increase your capital gains liability when you sell.
Not Always Clear Until Year-End: Interim ROC estimates can change and should not be used for tax filing.
Complexity: Investors need to track their adjusted cost basis carefully to avoid misreporting gains or losses.
For additional information, read more official documentation from YieldMax and Roundhill.
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