Tax planning plays an important role in the life of any successful income investor.
Since many preferred dividends are “qualified,” they are taxed at a lower rate than regular income. Knowledge of how preferred stock dividends are taxed can help investors determine their potential after-tax returns, as well as narrow down the best stocks to include in their portfolios.
While both preferred stocks and common stocks represent ownership in a company, they differ along several important criteria. Holders of common stocks typically have voting rights whereas investors in preferred stocks may not. However, holders of preferred stocks receive higher priority in terms of dividend distribution and company liquidation events than holders of common shares.
Additionally, dividends on preferred stocks are usually paid at planned intervals. Common stocks, on the other hand, may not have a fixed schedule, meaning the board of directors can actually decide to cut payments or not issue them at all. In this respect, the dividend on a preferred stock is usually guaranteed.
How Preferred Stock Dividends Are Taxed
Preferred stock dividends are taxed differently than other assets. When they are “qualified,” they incur lower taxation than even regular income. In order to be qualified, a U.S. company must exhibit a normal corporate structure and trade on any one of the major U.S. exchanges. Its shares must also have been owned by the investor for more than 60 days of the “holding period,” which describes a 121-day period that begins 60 days prior to the ex-dividend date. This broad definition generally means that most regular dividends paid out by U.S. corporations are qualified.
Keep track of stocks going ex-dividend by using our free Ex-Dividend Date Search tool.
Individuals, estates and trusts incur a capital gains tax rate of 15% on their qualified dividend holdings. For individuals with an income tax bracket lower than 22%, the capital gains tax is zero.
Recent changes to the tax law give income investors more savings than before. For example, dividend and capital gains are taxed at 20% for investors making over $425,800 and households earning more than $479,901. On the lower end of the spectrum, individuals earning between $38,601 and $425,800 are taxed at 15% for long-term capital gains.
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The following chart compares the tax rates for ordinary income and qualified dividends.
| Ordinary Income Tax Rate | Qualified Dividend Tax Rate |
|---|---|
| 0% | 0% |
| 12% | 0% |
| 22% | 15% |
| 24% | 15% |
| 35% | 15% |
| 37% | 20% |
Check out the complete list of preferred stocks here.
The Advantage of Qualified Dividends
Based on the chart above, it’s easy to see why qualified dividends have unique tax benefits.
Suppose an investor in the 35% tax bracket owns $200,000 worth of qualified dividend stocks with an average annual yield of 5%. Under this scenario, the investor would earn $10,000 annually from dividends. If those earnings were taxed as ordinary income, the investor would incur a liability of $3,500, bringing his total dividend income to just $6,500. However, as qualified dividends, the tax paid on the earnings falls by $2,000 to $1,500.
In short, income investors with a long-term perspective can use those additional savings to reinvest into dividend stocks for even bigger gains.
Implications of Withdrawals from Tax-Advantaged Accounts
Although tax-advantaged accounts, such as 401(k)s or traditional IRAs, can help investors grow their assets if reinvested, all proceeds are taxed as regular income when withdrawn. This is an important consideration that investors must carefully weigh when deciding which tax-deferred account to employ.
For example, the 401(k) contribution limit for 2017 was $18,000, with workers aged 50 and older allowed to contribute an additional $6,000. However, withdrawing any of the funds before retirement age would lead to stiff penalties.
If you’re below age 59½ and decide to withdraw $10,000 from your 401(k), that amount would be added as taxable income – but not before a 10% federal tax penalty. This means that your $10,000 withdrawal becomes $9,000. That $9,000 would be added to your personal income for the year. If your ordinary income was $85,000, the 401(k) withdrawal would bring you to $94,000. In 2018, that puts you in the 24% tax bracket, which means that $9,000 becomes $6,840 after taxes.
Preferred stock dividends can generate tremendous growth in a tax-sheltered account, especially if they are reinvested regularly. However, as the 401(k) example shows, these dividend-yielding stocks are susceptible to similar fees and taxation should they be withdrawn early.
Interested in learning more about preferred stocks? Check out the critical facts here.
The Bottom Line
With new tax reform in place, income investors have more reason to be optimistic about qualified dividends. As the previous discussion illustrates, utilizing qualified dividends for lower tax rates could be a boon to your investment portfolio and for your bottom line.
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