Many investors love collecting dividends from stocks and interest payments from bonds. Advisors and experienced market participants know that over extended holding periods, dividends can account for a fair amount of a portfolio’s overall returns and when it comes to the income lobbed off by bonds, that’s the primary reason to engage with that asset class.
Of course, investors never get something for nothing, meaning they’re on the hook for taxes related to those dividends and interest payments. Qualified dividends, the payouts courtesy of stocks, dividend ETFs and some preferred stocks, are taxed at the more favorable long-term capital gains rates while payouts from REITs and some fixed income ETFs are considered ordinary dividends, meaning they’re taxed at ordinary income rates.
The intersection of dividends and taxation is an increasing point of emphasis among both wealth managers and fund issuers, so much so that some ETFs seize upon the concept of after-tax alpha and eliminate dividends altogether. Thing is when the taxes are erased, so is the income offered.
Fortunately, there are avenues for adivsors and investors to tap high income while maintaining favorable tax treatment. Enter preferred stocks and the related ETFs.
Understanding Tax Treatment of Preferred Stocks
Preferred stocks are considered hybrid securities because they possess both equity and fixed income traits. However, preferreds are more arguably more tied to bonds because some have long-dated maturities and the asset class is rate-sensitive. The latter point makes preferreds and the related ETFs potentially attractive against the backdrop of expected easing this year by the Federal Reserve.
Alas, we’re talking taxes here so let’s get into the tax advantages of this high-yield asset class. In short, the dividends attached to most preferred stocks are treated as qualified dividend income (QDI).
“Preferred securities are a unique type of investment that sit between common stocks and bonds, offering higher income potential than common equity while still paying dividends rather than interest,” notes VanEck. “Many preferred securities pay dividends that qualify as qualified dividend income (QDI). When eligible, these dividends are taxed at long-term capital gains rates, rather than higher income tax rates. This can improve after-tax income, particularly for clients in higher tax brackets. ”
VanEck is the issuer behind the VanEck Preferred Securities ex Financials ETF (PFXF) -- a $2. 13 billion ETF that yields a tidy 6. 38% and turns 14 years old in July. That is to say the asset manager is knowledgeable about the tax benefits associated with preferred stocks.
Where Preferreds Go Matters
As advisors know, differing tax treatment for various income-generating assets means some are better suited for taxable accounts while others – namely those that throw off ordinary income – are better suited for tax-advantaged accounts.
That’s not to say an ETF like PFXF can’t to into an IRA, but it’s tax efficiencies are better suited for taxable brokerage accounts.
“Understanding where preferred-focused strategies like PFXF fit within an overall portfolio can help clients optimize after-tax income, not just pre-tax yield, and better align income generation with client objectives,” concludes VanEck.
