The search for fat dividends inevitably leads to preferred stocks, with their juicy yields that are almost guaranteed. However, "preferred" stocks come in a variety of flavors, only some of which pay dividends eligible for the qualified dividend tax rate of no more than 15 percent. The difference between a qualified and unqualified dividend can be substantial, depending on your tax bracket. In the 35 percent bracket, for example, an unqualified dividend would need to be $1.30 to match a buck's worth of qualified dividend.
According to the IRS, qualified dividends must be paid by a U.S. or qualified foreign corporation and not listed among dividends "that are not qualified dividends." Well, if that doesn't clear it up for you, try this: The dividend must be paid from the taxable cash flow of a company that's trying to make a profit. And don't worry: You don't have to figure this out. When you get your 1099-DIV from the custodian of your stock, it will tell you whether the dividend is qualified.
Check the Prospectus
If you want to know before you buy a preferred stock whether it pays a qualified dividend, check the prospectus. If you can't find the information or it's not there -- sometimes companies write a prospectus as if you inherently know such stuff -- check with the company's investor relations department.
There's one other thing that makes a dividend qualified: owning a stock long enough to satisfy the IRS's holding period rules. Make sure you know the stock's ex-dividend date, which is the first date you won't get the next dividend unless you already own the stock. For most stocks, including most preferred stocks, for the dividend to be qualified, you must own the stock for at least 60 days of the 121-day period that begins 60 days before the ex-dividend date. However, for preferred stocks that pay dividends annually, you must own the stock for 90 days in a 181-day period that begins 90 days before the ex-dividend date.
Traditional Preferred Stocks
Traditional preferred stocks – where the buyer gets a fixed, usually higher, dividend in exchange for giving up any stock ownership voting rights – typically pay qualified dividends. Banks, utilities and some large industrial companies are the primary issuers of traditional preferred stocks nowadays.
Unqualified Dividend Examples
Although real estate investment trusts – known as REITs – often issue traditional preferred stocks, those dividends are not qualified because of the companies' special tax status. Trust-preferred stocks, which sometimes have TruPS in their identifying title, and third-party trust-preferred stocks pay unqualified dividends as well. Dividends from exchange-traded debt securities, sometimes lumped with preferred stocks on stock tables, also are unqualified.
Convertible Preferred Stocks
Convertible preferred stocks, which you can exchange for a fixed number of the company's common shares whenever you want, carry qualified dividends. Convertible preferred stock also can be called by the issuing company when its common stock reaches a predetermined price. Mandatory convertible securities, which have a fixed conversion date but a variable conversion rate, pay unqualified dividends.
It makes no difference whether a preferred stock dividend is qualified when the security is held in a 401(k) plan, traditional IRA or another tax-deferred account. The proceeds from all dividends get treated as ordinary income when withdrawn from a tax-deferred account
The way the tax legislation was written creating qualified dividends, payments from most foreign preferred stocks as well as from foreign trust-preferred stocks and foreign exchange-traded debt securities qualify for the 15 percent treatment.
- What Happens When Companies Pay a Dividend?
- Are Qualified Dividends Taxable?
- How to Calculate Outstanding Shares That Qualify for Dividends
- Are Dividends Paid to Preferred Stock Holders Tax Deductible?
- How to Calculate Taxes on Ordinary Dividends
- Dividends Vs. Long-Term Capital Gains
- The Eligibility Requirements for Shareholders in the Subchapter S Corporation
- How to Calculate the Annual Dividend on Preferred Shares