Though preferred stock dividends are fixed like interest on a bond, they are taxed differently. Many preferred dividends are qualified and are taxed at a lower rate than normal income. Except for investors in the highest tax bracket who pay 20% on qualified dividends, most preferred shareholders owe only 15%. People in ordinary income tax brackets at 15% and below pay no tax on qualified dividends. Each preferred stock issue has a prospectus that details the structure, helping an investor to determine the taxable nature of its dividends. It is generally assumed that all dividends paid on preferred stock fall under the ordinary dividend category; however, Form 1099-DIV explains if any part of the dividends is from a different category, such as return of capital.
While technically classified as an equity, preferred stock has characteristics of a bond, including a stated par value and fixed cash payment amount. Preferred shareholders are higher in the pecking order than common shareholders for both dividend distributions and company liquidation events; however, they have no voting rights like common shareholders. Unlike with debt, if the issuing company is short on cash, the board of directors may elect to withhold the dividend from both common and preferred shareholders. Many preferred shares are issued as cumulative, meaning if dividends are withheld, they are still accrued and owed to preferred shareholders at a later date when cash becomes available. For example, during its financial struggles in 2006, Ford Motor Co. had to suspend dividends. Once the company stabilized, cumulative preferred shareholders were paid for the period withheld.
Donald P. Gould
Gould Asset Management, Claremont, CA
Most preferred stock dividends are treated as qualified dividends, meaning they are taxed at the more favorable rate of long-term capital gains. Some preferred stock dividends are not qualified, however. For example, dividends from trust preferred stock issued by a bank, which are taxed at the higher rates applicable to ordinary income. The maximum federal rate on ordinary income is 37%. Your brokerage firm can tell you whether a particular preferred stock generates qualified dividends.
An easier, more liquid and better diversified way to hold preferred stocks is through a mutual fund (including ETFs). If the dividends received by the fund are qualified, the portion of the fund's dividends paid to you will also pass through to you as qualified.