PREFERRED
STOCK NEWS
Are Lower
Tax Preferred Stock Dividends Really a
Better Deal?
Preferred
stock investors who acquire shares in a
regular income account rather than a
tax-deferred account such as an IRA, will
often favor issues that are designated as
qualifying for a lower tax treatment.
Dividend income that qualifies for the more
favorable tax rate is referred to as
Qualified Dividend Income (QDI).
QDI qualification
The
designation comes from the idea that if your
dividends are paid to you out of the
company’s after-tax profits, you get a tax
break since the company has already paid
corporate income tax on the money (the
question of why you should have to be taxed
on money that the issuing company has
already paid tax on will forever remain a
favorite political football).
Conversely, if your dividends are paid to
you out of the company’s pre-tax revenue
(such as in the case of preferreds issued by
REITs), then your dividends are taxed at
your regular income tax rate – you, rather
the company, pay the full tax.
The tax break that you get for QDI-qualified
preferred stock dividends depends on which
tax bracket you fall into. This table shows
the QDI tax rate for each federal income tax
bracket.
(Source:
Wikipedia,
Wikipedia.com)
Six to pick from
Of the 765 preferred stocks trading today (traditionals,
trust and 3rd-party trust), 407 are
designated as paying QDI dividends (53
percent). That’s the good news. The bad news
is that most risk-averse preferred stock
investors would probably avoid almost all of
these.
Of the 407 QDI-designated preferreds trading
today, only 211 offer cumulative dividends.
And looking for those with an investment
grade Moody’s rating drops the list down to
131. But even at that, 70 out of the
remaining 131 are so old that they have
become illiquid (daily volume is zero since
there are no sellers); that leaves 61.
Most of these 61 were issued at a time when
rates were higher than today, making
redemption of the shares highly likely. Who
wants to purchase shares and have the
issuing company call them the next day? If
you are looking for call protection of at
least a year (to avoid short-term capital
gain treatment), you’re actually down to
eight preferred stocks, six of which have
the $25 par value that most preferred stock
investors favor (the other two have $1,000
and $100 par values and are aimed at
institutional investors).
So here is the list of the six QDI-designated
preferred stocks that offer cumulative
dividends, investment grade ratings, a
non-zero trading volume with at least one
year of call protection and a $25 par value
(sorted by Current Yield, highest to
lowest).
Note that the
highest QDI-designated payer is the new GRX-B
at 5.875 percent. Just issued in September,
GRX-B has yet to declare its first dividend
but is expected to shortly.
(Source:
CDx3 Notification Service database,
PreferredStockInvesting.com)
Compared to very similar non-QDI preferreds
Using the same criteria as a filter, here
are the top six non-QDI preferreds with the
highest current yield (November 25, 2014
prices).
For
comparability, I sorted these lists by
Current Yield here rather than Yield-To-Call
or Effective Annual Return so the yield
values indicate the annual dividend return
(i.e. the shares are not sold within the
first year so no capital gain/loss or
reinvested dividend income is reflected in
the yield values seen here).
Notice that while QDI-designated preferreds
offer a lower tax rate than their non-QDI
peers, they also pay less dividend income to
begin with. In other words, the tax benefit
offered by the six QDI-designated preferred
stocks is at least partially offset by the
lower dividend rate they offer when compared
to very similar non-QDI preferreds.
So at what
point is a preferred stock investor actually
benefiting from the lower tax rate offered
by QDI-designated preferred stocks?
Results
The answer, of
course, depends on which specific preferred
stocks are being compared and which tax
bracket you fall into. But let’s look at the
QDI-designated preferred stock that offers
the highest dividend income, GRX-B. As the
highest QDI-designated payer, GRX-B has a
coupon of 5.875 percent.
With a $25 par value, GRX-B pays $1.46 per
year in QDI dividend income ($25 times 5.875
percent). The 15 percent QDI tax is $0.22
per share, so your after-tax dividend income
is $1.24 per year for every share of GRX-B
that you own ($1.46 minus $0.22).
Running this calculation for each of the six
non-QDI peers shows us the break-even point
for GRX-B – the non-QDI dividend rate at
which your after-tax income is the same as
GRX-B’s $1.24.
Notice that
all of the non-QDI peers are issued by
REITs. Remember that, come tax time, a
portion of your dividend income earned from
REIT preferred stocks will be reclassified
as capital gain income which is taxed at a
lower rate than the 28 percent used here.
Consequently, this analysis understates the
after-tax income earned from the non-QDI
peers shown here.
The break-even dividend rate, where you
start to become better off by purchasing
non-QDI shares rather than shares of the QDI-designated
GRX-B, is 6.875 percent. The after-tax
income earned from a 6.875 percent non-QDI
preferred stock is the same as the after-tax
income earned from the highest paying QDI-designated
preferred stock, GRX-B, at 5.875 percent
(assuming a 28 percent regular income tax
bracket).
Put another way, while being QDI-qualified
lowers the tax rate applied to your dividend
income, the lower coupon rate that QDI-qualified
preferred stocks offer can eliminate the tax
savings when compared to similar non-QDI
alternatives.
But that can actually be good news for
preferred stock investors because that also
means that restricting your choices to QDI-qualified
preferred stocks may not be necessary. In
fact, there are currently 21 non-QDI,
call-protected preferred stocks offering
cumulative dividends and investment grade
Moody’s ratings with coupon rates greater
than GRX-B’s 6.875 percent break-even point.
The after-tax dividend income from any of
these 21 non-QDI issues exceeds the
after-tax dividend income received from GRX-B
(the highest QDI payer).
These results will vary, of course,
depending on how the math works out with the
particular alternatives you may be
considering. By increasing your investment
risk (by including non-cumulative issues or
those that do not offer investment grade
ratings), your list of QDI-qualified
candidates grows.
And this analysis does not consider the
capital gain/loss/call protection/redemption
risk that comes with purchasing shares for
above-par prices since the extent to which
any of those materialize is unknowable.
But this apples-to-apples comparison, or as
close as I could get to it, indicates that
favoring QDI-designated preferred stock for
your regular income (non-IRA) account may
not be delivering the after-tax benefit that
you’ve been counting on.
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