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Section 1256 and covered call ETFs: what the 60/40 rule really does

Options on a broad stock index fall under Section 1256 of the US tax code. Gains on them are taxed as 60% long-term and 40% short-term, no matter how long they were held. That can lower the tax on a fund's option gains in a taxable account. In an IRA, a 401k, a TFSA or an RRSP, it changes nothing.

Options guide · 8-minute read · Updated 2026-10-28

The short answer

Section 1256 is a US tax rule for certain contracts, including options on a broad stock index like the S&P 500 or the Nasdaq-100. Gains and losses on them are split 60% long-term and 40% short-term, even if the option lasted only a week.

Most option sellers pay the short-term rate on everything, because their options rarely last a year. So a fund that sells index options can turn part of its option gains into lower-taxed gains. That's the tax angle funds like SPYI and QQQI are known for.

It only matters where gains are taxed every year. Inside a tax-sheltered account, the label on the gain is irrelevant.

This page isn't a recommendation to buy or sell SPYI, QQQI or any fund. Tax rules are as of October 2026; the IRS instructions for Form 6781 are where the 60/40 rule is spelled out.

Why index options and ETF options are taxed differently

There are two kinds of options that look alike on a screen:

• Options on an ETF or a stock, like SPY or QQQ. These are equity options. A gain on a short call held under a year is a short-term gain, taxed like ordinary income.
• Options on the index itself, like SPX or NDX. These are broad-based index options. They count as Section 1256 contracts, so the 60/40 split applies.

Index options are usually European-style options and Cash-settled options: no shares change hands, and they can't be exercised early. Our SPY vs SPX options page lays out the other differences.

Section 1256 has a second rule people miss. Open contracts are treated as sold at their market value on the last business day of the year. You owe tax on the gain, or book the loss, even if you never closed the trade. A fund handles that for you, but it's part of the deal.

How a covered call ETF uses it

A Covered-call ETF sells calls and pays you the premium as a Distribution. What changes is which options it sells:

• A fund that sells calls on SPY or QQQ shares earns short-term option gains.
• A fund that sells calls on the SPX or NDX index earns Section 1256 gains, split 60/40.

The fund doesn't pass the 60/40 split to you line by line. It sums up its gains and losses for the year. Then your US tax slip, Form 1099-DIV, sorts the payout into boxes: ordinary dividends, capital gain distributions, and Return of capital. Index-option gains can raise the long-term share of that mix.

Two more things shape what you actually owe:

• Losses count too. If the fund's calls lose money in a rally, those are Section 1256 losses, split the same way. They can offset gains inside the fund.
• Return of capital isn't taxed on arrival. It lowers your Cost basis instead. Some index-option funds report a large share of their payout this way. See return of capital in covered call ETFs.

The fund's year-end tax notice is the only source for the real split. It changes every year.

A worked tax comparison (hypothetical)

Here's the rule on its own, with made-up round numbers (an illustration, not a trade idea).

Say a fund's option gains handed to you come to $10,000 in a year. You're in a taxable US account. Assume a short-term rate of 32% and a long-term rate of 15%. Your real rates depend on your income.

In this example the 60/40 split saves $1,020 of tax on the same gains.

Now look at the last row. The tax rule does nothing for the share price. If the fund's price falls because it took the market's drops and got capped on the rallies, you lose that money under either label. A lower tax bill on a payout doesn't make up for a shrinking fund. Read how covered call ETFs work for why the price drifts.

Why it means nothing in an IRA, a 401k, a TFSA or an RRSP

The whole benefit is a lower tax rate on gains taxed each year. Some accounts don't tax gains each year at all:

So inside an IRA, a SPYI-style fund and a SPY-call fund are taxed the same: not at all, until you withdraw. The choice between them comes down to how they're built, their fees and their Total return.

For Canadians, the bigger tax question with a US-listed fund is the withholding tax on its payout. That one can bite in a TFSA. See US covered call ETFs in a TFSA: the withholding tax. Covered calls are widely allowed in a TFSA and an RRSP if you'd rather sell your own, but options permissions differ by broker.

Can you get the same tax treatment yourself?

Yes, in a taxable US account. If you sell calls on SPX or NDX instead of SPY or QQQ, your own gains get the 60/40 split. There are two catches. One index option covers a much bigger amount of stock than one SPY option. And because nothing is delivered, an index call isn't "covered" by shares the way a SPY call is, so most brokers treat it as an uncovered call. That needs a margin account and a higher options level; check your broker's rules. Many sellers who want small, flexible trades stick with SPY options and accept the short-term rate.

Doing it yourself also lets you pick the strike, the date, and when to sit out. That's what the wheel strategy is about. For the plain mechanics of the trade, read our covered call strategy guide.

What to check before you buy for the tax angle

1. Which account will hold it? If it's an IRA, a 401k, a TFSA or an RRSP, ignore the tax pitch.
2. What does the fund actually sell? Its prospectus says whether it uses index options or ETF options.
3. What did last year's tax notice show? The split between ordinary dividends, capital gains and return of capital.
4. What was the total return? Price change plus payouts, against a plain index fund over the same years.

Questions