How Are Preferred Stock Dividends Taxed?

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How Are Preferred Stock Dividends Taxed?

Though preferred stock dividends are set, similar to bond interest, they are taxed differently. Many preferred dividends are taxed at a lower rate than ordinary income. With the exception of investors in the highest tax band, who pay 20% on eligible dividends, the majority of preferred shareholders pay just 15%. Qualified dividends are tax-free for those in ordinary income tax levels of 15% or below.

Each preferred stock offering includes a prospectus that outlines the structure, allowing an investor to assess if the dividends are taxable. It is often considered that all dividends received on preferred shares are classified as regular dividends; however, Form 1099-DIV clarifies whether any portion of the income is classified as return of capital.

Key Takeaways

  • Preferred stock often pays more dividends than ordinary stock, making it more similar to debt than typical equity.
  • Although dividends are paid in the same manner as bonds, they are taxed as qualified dividends rather than interest.
  • That is, rather than the marginal income tax rate, preferred dividends are taxed at a rate ranging from 15% to 20%.

Preferred Stock

While officially classed as an equity, preferred stock contains bond-like features such as a declared par value and a set cash payment amount. Preferred shareholders rank higher than regular shareholders in terms of dividend payments and corporate liquidation events, although they do not have voting rights like common shareholders.

In contrast to debt, if the issuing firm is short on cash, the board of directors has the option to withhold dividends from both regular and preferred shareholders. Many preferred shares are cumulative, which means that even if dividends are withheld, they are still accumulated and owing to preferred owners when income becomes available. Ford Motor Company, for example, had to halt payouts amid its financial difficulties in 2006. Once the firm had stabilized, cumulative preferred stockholders were paid for the time that they had been withheld.

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Advisor Insight

Donald P. GouldGould Asset Management, Claremont, Calif.

Most preferred stock payouts are considered as qualified dividends, which means they are taxed at the lower long-term capital gains rate. However, certain preferred stock distributions are not eligible. Dividends from a bank’s trust preferred shares, for example, are taxed at the higher rates applicable to regular income. The federal maximum tax rate on regular income is 37%. Your brokerage company can inform you whether a certain preferred stock pays eligible dividends.

A mutual fund provides a simpler, more liquid, and more diverse method to hold preferred stocks (including ETFs).If the fund receives qualifying dividends, the share of the fund’s dividends distributed to you will be qualified as well.

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