Are Covered Calls Safe in Retirement?

Many retirees struggle to have enough income to live in retirement, even if they have accumulated retirement savings.

Are covered calls safe in retirement as a way to generate income?

The answer to this question depends on several factors. In this post I’ll address:

  • When covered calls are safe for retirement 
  • When covered calls are not safe for retirement
  • 4 dangers of covered calls in retirement specifically
  • A successful covered call strategy for many retirees 

Let’s get started. 

When Covered Calls Are Safe For Retirement Income

Covered calls are generally safe for retirement income when retirees can handle the risk of the underlying stocks declining in value. 

Here’s the thing: Many retirees equate options with risk. The risk with covered calls, however, comes from the fact that underlying shares must be owned to cover the calls being sold. So, the risk comes from owning stocks, which most investors already do anyway! 

There is little to no risk from actually selling the covered calls; if the calls get exercised, your shares will automatically be sold at the option strike price, end of story.

When Covered Calls Are Not Safe For Retirement

Covered calls aren’t safe for retirement:

  1. When an investor has too much of their retirement savings allocated to stocks
  2. AND a significant decline occurs in the value of owned stocks  
  3. AND the decline was so large the retiree couldn’t make planned retirement withdrawals as long as needed because the stock portfolio value dropped so much
  4. OR the retiree doesn’t truly understand how covered calls work

This risk applies to all stock investors, though, and not to covered call strategies.

Therefore, the safety issue is risk management for retired stock investors in particular. This is because most retirees:

  1. Are investors over 50 or older
  2. Don’t have decades to recover from stock market losses before retirement
  3. Don’t have extra employment income to increase retirement savings

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The Dangers of Covered Calls in Retirement

There are several dangers of covered calls in retirement specifically, besides stock market risk

Capital Gains Taxes

Capital gains taxes might be owed when shares are sold. Many retirees have long term stock holdings with costs that are a fraction of market value. This means that the difference between the option strike price and the stock cost could trigger a nice fat capital gain.

As much as investors love capital gains, unexpected taxes on capital gains can be problematic. Undesired exercise of call options sold is one of the biggest problems with covered calls

The tax issue could be inconsequential if the covered call was sold in a retirement account, however. It depends on the type of retirement account used for selling covered calls. 

Tax on Covered Call Income

Income received from selling the call options outside of a retirement account is taxed as regular income which falls into the highest tax rate. It could even push a retiree into a higher tax rate such as the big jump from 12% to 22%.  

Reliance on Covered Call Income

Basic covered calls only work for sideways and up trending stocks or ETFs. Stock bull markets have historically lasted for many years. Retirees can easily become accustomed to covered call income during such times. 

The reality is an investor can lose what was once a steady retirement income when an extended bear market occurs. (Been there and done that.)

This is particularly problematic when a bear market lasts a long time, which does happen occasionally. 

The solution for this danger is to have several retirement income sources other than just relying on covered call strategies

Limited Upside for Underlying Stocks

One problem with covered calls is that upside potential from the underlying stock is limited. Most retirees, however, are more focused on investment income than capital gains

A Popular Retirement Covered Call Strategy

Many older investors or retirees, specifically, have a large holding in only one stock due to long term employment, resulting in owning hundreds or thousands of shares. 

Often, these huge positions cost significantly below the market value of the stock. This has been the situation with a number of my financial coaching clients. 

In this situation, a retiree can make a significant income by selling out of the money covered calls on the stocks. 

It’s important to address here that I encourage diversification to reduce risk. Many investors, however, have fallen so in love with the stocks that have built wealth for them that they cannot bring themselves to sell.    

Summary: Are Covered Calls Safe for Retirement?

The primary takeaway is that the primary risk from covered calls is from the underlying stocks losing value. This is a risk that should be managed for all stock market investors, not just retirees.

The information on this website is for education only and is not to be construed as personal financial advice.