As you build your investment portfolio, you might like to allocate a portion to income-producing securities. While bonds and other interest-bearing instruments quickly spring to mind, preferred shares can offer similar income levels and help you reap a tax break. Alas, preferred dividends are tax-deductible to neither issuers nor recipients.
Preferred Share Basics
Preferred shares are a form of stock that resembles a bond. They pay a fixed dividend that competes with the interest payments served up by long-term bonds. While preferred stock does not guarantee its dividends, corporations must pay these before shelling out any common stock dividends. If a corporation goes bankrupt, preferred shareholders receive liquidation proceeds ahead of common shareholders but after bondholders. Just like common stock, preferred shares may be bought and sold on stock exchanges,
Corporations get to deduct interest payments on debt from their taxes. When they prepare their income statements, corporations subtract these interest payments from their gross income as they calculate their net profits. Corporations pay dividends out of post-tax accumulated profits called retained earnings. Corporations cannot deduct dividends from their taxable income. The Internal Revenue Service taxes dividends twice -- once at the corporate level and again when you receive them.
Most preferred dividends qualify for a lower tax rate. For dividends to qualify, the issuing corporation must pay taxes on its earnings and its stock must be easily available to trade in the United States. In addition, you must own the dividend-paying preferred shares for at least 60 days of the 121 days surrounding the ex-dividend date, which is the first date on which the shares trade without the current dividend. If the preferred dividend is due to periods exceeding 366 days, the holding period is 90 days for the 181 days surrounding the ex-dividend date. If your dividends do not qualify for the lower tax rates, you treat them as ordinary income, taxable at your marginal interest rate -- the tax rate on your “last dollar” of income for the year.
Tax Rates for Qualified Dividends
If a single filer's modified adjusted gross income exceeds $400,000 -- $450,000 for a married couple -- qualified dividends are taxed at 20 percent. Below those thresholds, the tax rate shrinks to 15 percent unless your marginal tax bracket is below 25 percent, in which case your qualified dividends become tax-free. You record dividend income in the year it is declared. Your broker will send you and the IRS copies of Form 1099-DIV in January identifying your dividend income for the previous year. You record your dividend income on Form 1040.
If you are filing as single and your modified adjusted gross income exceeds $200,000 -- $250,000 for couples -- you are on the hook for a 3.8 percent Medicare surcharge. Dividends increase both your MAGI and your investment income, which also includes interest payments and capital gains. You figure your Medicare tax on the lesser of your investment income or the amount by which your MAGI exceeds the noted thresholds.
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- Does a Preferred Dividend Have to Be Paid?
- The Difference Between Qualified & Ordinary Dividends