As April 15 approaches, many investors are realizing that a lot of their gains have a date with the IRS. When it comes to personal finance, tax efficiency is important to keeping as much of your gains as possible. For income investors, knowing certain tax rules can make tax time a lot less painful and allow you to keep more of what you gained.
Interest vs dividends
Regarding total income amounts, there is a lot in common between interest payments and dividend payments. But for the purposes of taxes, they are treated very differently. Interest income is taxed at your ordinary income tax rate while qualified dividend income is taxed at a (usually) lower tax rate.
For investors looking at preferred stocks, the difference here can be critical. Often mixed in with preferred stocks are exchange traded debt securities, which pay interest instead of dividends.
Take these insurance examples for instance. Aegon 8.00% Non-cumulative subordinated notes (NYSE:AEK) show up alongside preferred stocks in many screeners. But this issue is made up of debt securities that pay interest, not dividends, and therefore have the payments taxed at the ordinary income tax rate.
A more tax efficient alternative for higher income earners would be MetLife Series B preferred stock (NYSE:MET-B). Since it's actual preferred stock and not exchange traded debt, this series pays income investors with dividends, not interest, making the payments eligible for the qualified dividend tax rate if all other requirements are also met (more on this later).
REIT preferred stock tax alert
Not all preferred stocks are eligible for the qualified dividend tax rate however. Dividends from REIT preferred stocks do not get the same tax benefits as dividends from most other companies.
One example can be found in NorthStar Realty Finance Corp Series A preferred stock (NYSE:NRF). Although this is a type of preferred stock, it is not eligible for the qualified dividend tax rate. When making income investment decisions, it is important to take this into account.
Qualified dividend tax rate
Getting the qualified dividend tax rate requires more than just picking the right investments. The IRS is very clear on what other requirements are needed to obtain a lower tax rate.
Among them are holding period requirements (at least 60 days prior for common stock and at least 90 days prior for preferred stock) and that the dividends must be paid by either a U.S. corporation or a qualifying foreign corporation. For more details and examples of holding period situations and which corporations qualify, the IRS section on qualified dividends actually does a pretty good job explaining it.
Creating a tax efficient portfolio is essential to being able to keep the most of your gains as possible. By reviewing the differences between interest paying securities and dividend paying securities, you can better adjust your portfolio for maximum gains.
Of course each situation is unique and you should always run the numbers to see which income investment is really best for you. After all, taxes are just one part of the equation when it comes to investing.