Meet Required Minimum Distributions With Covered Calls

by Mike Scanlin

Required Minimum Distribution is the amount the federal government requires you to withdraw each year – usually after you reach age 70.5 – from retirement accounts, including traditional IRAs, simplified employee pension (SEP) IRAs and SIMPLE IRAs, as well as many employer-sponsored retirement plans.

A recent article in the Wall Street Journal, Covering RMDs With Covered Calls, discusses a couple over the age of 70.5 who had $1M of company stock in their 401k accounts. Their combined required minimum distributions (RMDs) were $36,500 per year, but the stock only paid $27,600 in dividends (approx 2.76% annual yield). How to make up the difference of $8,900 per year without selling any shares?

Enter Covered Calls

Generating $8,900/year from $1M of stock using covered calls is not a tall order. A 1% annual yield would be $10,000, so we're looking for just 0.89% per year.

You could sell a single 12-month option far out of the money to get 0.89% per year. Or you could sell a closer-to-the-money 3-month or 4-month option that had just enough time premium to generate the 0.89% and then leave the stock uncovered for the other 8-9 months of the year.

Texas Oil Company

The WSJ article didn't disclose which company the couple had worked for, but it did say it was in the Texas oil industry. If we look at oil companies that pay about 2.76%/year in dividends with operations in Texas it might have been Exxon Mobil (XOM), Helmerich Payne (HP), or Occidental Petroleum (OXY).

If we take the $8900 goal and divide by the number of shares that $1M of each of these companies represents, we find how much premium per year (after transaction costs) we need to earn (if we cover 100% of the position):

Generate The Premium With A 3 or 4-month Option

Here's one way to solve the problem using a 3-month or 4-month contract. Because the contracts are bid at more than the $/share needed for the year, you don't have to cover 100% of the position. Covering just a portion of it will generate enough income to meet the $8,900 annual goal:

Generate The Premium With A 12-month Option

Using a long-dated option requires advance planning. We're in the middle of the year right now so we'll have to illustrate this example with a 16-month option instead of a 12-month option. But the idea is the same... each January you would sell an option for the following January (1 year out) that would generate enough premium to cover that year's RMD. For example, here are the January 2016 options that meet the goal of $8,900:

Because of the longer time until expiration, we can use higher strike prices to get the same premium. That gives the stocks more room to run (upside potential). And we don't need to cover 100% of the position, since the premium per contract is higher than our minimum. The only drawback is if the company exceeds the strike price by Jan 2016.

If that time horizon is too long then another choice is to use weekly options several times per year, so that the sum of the premium received exceeds $8,900 for the year. You'd probably only need to cover the position a few weeks per year, and could then leave it uncovered during all the other weeks of the year. The choice depends on how much time you want to spend managing the position.

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.

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