Good News For Index Investors

The definition of a narrow-based index has changed and, as a result, the overwhelming majority of exchange-listed index options now count as “broad-based”. This is good news for most index investors because broad-based index derivatives receive more generous tax treatment than narrow-based indexes or exchange-traded funds based on those indexes.

With interest in index funds and exchange-traded funds exploding, investors with bearish sentiments or short-term horizons should make their investments through listed index options.

The Jobs and Growth Tax Reconciliation Act of 2003 lowered the short-term capital gain tax rate to 35%.  Thus for top bracket investors, the blended rate for profits on broad-based index options is 23%. The maximum tax rate for profits on listed narrow-based index options is 35%. Currency contracts can also get favorable tax treatment.

The profits on broad-based index options (now encompassing most index options previously defined as narrow) are automatically treated as 60% long-term and 40% short-term capital gains, so a top bracket investor would pay a blended rate of 27.8% on such gains. (27.8% equals 60% of 20% plus 40% of 39.6%). This favorable tax rate is available to short positions as well. It should be noted, however, that these exchange-listed broad-based indexes are marked to market at year-end, so the investment is taxed annually.

Of the approximately 64 exchange-traded index options, Twenty-First Securities knows of only about a dozen that meet any of the new criteria to be classified as narrow-based, and only a couple of those have meaningful volume.  These remaining listed narrow-based options continue to be taxed the same way as stocks, bonds and funds, so if an investor is in the top tax bracket, the maximum toll on narrow-based index gains will be 39.6%. The same treatment applies to all over-the-counter options (except options on currencies).

In some cases, an index option may fluctuate between broad-based and narrow-based.  Twenty-First Securities has created a table that classifies exchange-traded index options as broad-based or narrow-based.  The table is updated periodically.

The new definition is contained in a bill dealing with the taxation of forthcoming single stock futures contracts.  The law became effective on December 21, 2000.

This article and other articles herein are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein. Options involve risk and are not suitable for all investors.  Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".