All corporations issue stock, which typically gives stockholders a share of ownership in the company, certain voting rights and the often the opportunity to receive dividends, or distributions of company profit. Those dividends aren't guaranteed, however. Some companies issue a special kind of stock, preferred stock. These shares don't usually carry voting rights, but their dividends are generally paid ahead of those paid to common stock holders. Knowing how taxes affect preferred shares can help you make smart investment decisions.
The stock that acts like a bond
Though it's technically stock, a preferred share is more like a bond. The dividend paid by the corporation can provide steady income to the shareholder, much like bondholders receive regular interest payments from the bond issuer.
Preferred stock also can usually be "called" by the company, meaning that the company can require preferred stockholders to sell the shares back to the company or exchange them for common shares. Bonds are often callable, as well.
Less volatility means lower capital gains
Preferred shares are considerably less volatile than common shares, meaning their price is less likely to experience big ups and downs. That's because the dividend payout essentially ensures that the price won't fall below a certain level, and the callable nature of preferred shares keeps the price from rising above a certain level. (The company might call the shares if their value got too high.)
As a result, investors usually can't sell their shares for much more, or much less, than they paid for them. That, in turn, means that selling preferred stock is less likely to produce either a taxable capital gain or a capital loss than can be deducted against other income. Keep this in mind when considering when to sell preferred shares.
Qualified dividends taxed at lower rates
Dividends on preferred shares are taxable income, but the tax rate you pay depends on whether the IRS considers the dividends to be "qualified." Qualified dividends are taxed at lower rates than ordinary income. As of 2020, the tax rate ranges from 0 % to 20% depending on your tax bracket.
Bond interest, by comparison, is usually taxed as ordinary income. If you're trying to decide between bonds and preferred stock, be sure to take these potential tax savings into account. Of course, you must also make sure that your preferred stock dividends would be qualified.
Meeting the holding period requirement
Preferred dividends are qualified if they meet several criteria. The one investors must be most aware of is the holding period, or how long you've owned the stock. Meet the holding period requirement, and you'll usually owe a lot less in taxes on your dividends.
For most dividends, you can ensure that you meet the holding period requirement by buying the stock at least 60 days before the "ex-dividend" date, or "ex-date." This is the date on which you must be listed as the owner of the share to receive the dividend.
If the preferred stock pays dividends less than once a year—which is unusual but has been known to happen—then you can ensure that you meet the holding period requirement by buying the stock at least 90 days before the ex-date.
Since preferred dividends are usually pre-determined, their ex-dates are often predictable. Look up the shares on a financial website, or on the investor information section of the company's website, to find out how often the stock pays dividends and the ex-date.