How Preferred Stock Dividends Are Taxed

Preferred stock dividends are taxed differently than other investment income. Generally, these dividends are classified as either qualified or non-qualified. Qualified dividends are taxed at the lower capital gains rates, which can range from 0% to 20%, depending on the investor’s income bracket. Non-qualified dividends, on the other hand, are taxed at ordinary income tax rates, which can be higher than the capital gains rates. The exact rate depends on the individual’s tax bracket. For hands-on advice, a financial advisor who specializes in tax planning can help you create a plan to minimize your liability.

What Is a Preferred Stock Dividend?

A preferred stock dividend is a payment made to shareholders who own preferred shares of a company’s stock. These dividends are a key feature that distinguishes preferred stock from common stock, offering investors a more predictable and often higher income stream. Preferred stock dividends are typically fixed, meaning they are paid out at a set rate, unlike common stock dividends, which can fluctuate based on the company’s profitability and board decisions.

One of the main advantages of preferred stock dividends is their priority over common stock dividends. Companies are obligated to pay preferred dividends before any dividends can be issued to common shareholders. This priority makes preferred stock an attractive option for investors seeking steady income with a lower risk of dividend cuts.

Additionally, many preferred stocks have a cumulative dividend feature, ensuring that any missed dividend payments must be paid in full before common shareholders receive their dividends. This provision provides an extra layer of security for preferred stockholders.

Preferred stock dividends can also offer tax advantages, as many are considered qualified dividends. Qualified dividends are taxed at the lower capital gains tax rate, which can be significantly less than the ordinary income tax rate applied to non-qualified dividends. This favorable tax treatment can enhance the after-tax return for investors holding preferred stocks, making them an appealing option for those in higher tax brackets.

Another unique aspect of preferred stock dividends is their potential for higher yields when compared with common stock dividends. Because preferred dividends are fixed and prioritized, companies often offer higher dividend rates to attract investors. This can result in more income, especially in a low-interest-rate environment where bond yields may be less attractive.

You should also note that preferred stock dividends also carry some risks. Companies can defer or suspend dividend payments if they face financial difficulties, particularly if the preferred stock is non-cumulative. Moreover, preferred stocks often have a callable feature, allowing the issuing company to repurchase the shares at a set price after a certain date. This callability can limit the potential for price appreciation and affect the long-term income stream for investors.

How Are Preferred Stock Dividends Taxed?

A financial advisor discussing strategies to reduce taxes on dividend income.

Preferred stock dividends have unique tax considerations that can significantly impact an investor’s after-tax returns. Generally, these dividends are classified as either qualified or non-qualified, with each category subject to different tax rates:

Tax treatment of qualified dividends: Qualified dividends are taxed at the lower long-term capital gains rates, which can be 0%, 15% or 20%, depending on the investor’s taxable income. To qualify, the dividends must be paid by a U.S. corporation or a qualified foreign corporation, and the investor must meet certain holding period requirements, typically holding the stock for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date.
Tax treatment of nonqualified dividends: Non-qualified dividends are taxed at the investor’s ordinary income tax rates, which can be significantly higher than the rates applied to qualified dividends. These rates range from 10% to 37%, depending on the individual’s income level.

Another important consideration is the tax treatment of dividends from preferred stocks held in tax-advantaged accounts, such as IRAs or 401(k) plans. In these accounts, dividends typically grow tax-deferred, meaning investors do not pay taxes on the dividends until they withdraw the funds, usually during retirement. This can provide a significant tax benefit, especially for those in higher tax brackets during their working years.

Additionally, the timing of dividend payments can affect tax liabilities. For example, receiving a large dividend payment at the end of the year can push an investor into a higher tax bracket, increasing the overall tax burden. Strategic planning, such as spreading investments across multiple tax years or utilizing tax-advantaged accounts, can help mitigate this impact.

State taxes also play a role in the overall tax consideration for preferred stock dividends. While federal tax rates are a primary concern, state tax rates can vary widely, and some states may have favorable tax treatments for dividend income. Investors should be aware of their state’s tax policies and consider consulting a tax professional to navigate these complexities.

Tips for Reducing Taxes on Dividend Income

Dividend income can be a valuable source of earnings, but it also comes with tax liabilities that can eat into your returns. Fortunately, there are strategies you can employ to minimize the taxes on your dividend income, helping you retain more of your investment gains.

Here are seven practical tips to consider:

Invest in qualified dividends. Qualified dividends are taxed at the lower long-term capital gains rates rather than the higher ordinary income tax rates. To take advantage of this, ensure that your dividends meet the IRS criteria for qualified status.
Use tax-advantaged accounts. Placing dividend-paying investments in tax-advantaged accounts such as Roth IRAs, traditional IRAs or 401(k) plans can defer or eliminate the taxes on your dividend income. This allows your investments to grow tax-free or tax-deferred until withdrawal.
Consider tax-efficient funds. Investing in tax-efficient mutual funds or ETFs that focus on minimizing taxable distributions can help reduce your overall tax burden. These funds typically employ strategies to limit dividend payouts and capital gains distributions.
Harvest tax losses. Offsetting dividend income with capital losses can reduce your taxable income. By strategically selling losing investments, you can use the losses to offset gains and lower your overall tax liability.
Stay within lower tax brackets. Keep an eye on your total taxable income and try to stay within lower tax brackets. This can help you take advantage of lower tax rates on your dividends. Strategies like spreading out withdrawals and timing your income can be effective.
Understand your state taxes. State tax laws vary, and some states have favorable treatments for dividend income. Be aware of your state’s tax policies, and consider relocating if it aligns with your long-term financial goals.
Hold investments long-term. Long-term investments benefit from lower capital gains tax rates compared to short-term capital gains rates. Holding onto your investments for longer periods can reduce the overall tax impact on your dividend income.

Bottom Line

A couple reviewing dividend investments.

The classification of dividends as qualified or non-qualified significantly impacts the tax rate applied to preferred stock dividends, with qualified dividends benefiting from lower capital gains rates. Additionally, leveraging tax-advantaged accounts can defer taxes, enhancing long-term growth potential. State tax considerations and strategic dividend timing also play important roles in managing tax liabilities.

Tax Planning Tips

If you need help with investment taxes, a financial advisor can work with you to optimize your portfolio for a lower tax liability. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you don’t know whether you’re better off taking the standard deduction versus itemizing your deductions, you might want to read up on it before the tax return deadline.