Taxable Preferred Securities

Delving into the World of Taxable Preferred Securities

Unraveling the Mystery of Taxable Preferred Securities

Taxable preferred securities might sound like a mouthful, but let's break it down. These are essentially preferred stocks whose dividend payouts aren't tax-exempt. These securities operate much like bonds, traded in denominations of either $25 or $1,000 par value. While the $25 par securities are a favorite among retail investors, institutional investors typically gravitate towards the $1,000 par securities.

The Intricacies of Taxable Preferred Securities

Unlike their tax-exempt counterparts, taxable preferred securities don't qualify for the dividends-received deduction, a tax break cherished by corporations. Instead, the IRS categorizes the dividends from these securities as regular income, which can be a bit of a downer for individual investors. However, this less-than-ideal tax treatment does come with a silver lining: taxable preferred securities often boast higher yields compared to their tax-exempt counterparts.

The rise in popularity of these securities can be traced back to the mid-1990s, sparking the birth of numerous funds and exchange-traded funds (ETFs) exclusively focused on these financial instruments. They are generally considered junior level liabilities and come with coupons that can either be fixed or variable, spanning both indefinite and specific maturities.

How Do Taxable Preferred Securities Compare?

Preferred stocks, often likened to the chameleons of the stock world, behave like bonds while also sharing similarities with common stocks. They prioritize dividend payouts to shareholders over common stock dividends. This makes them a go-to choice for investors who prefer a more predictable income stream and are wary of the volatility associated with common shares.

One distinctive feature of preferred stocks is their callable nature. Issuers reserve the right to redeem these shares at their discretion, offering a level of flexibility not commonly seen with common shares. However, if the dividends received from these stocks fail to qualify for the federal tax deduction, they fall into the taxable preferred securities category.

The Tax Implications of Preferred Securities

The concept of taxable preferred securities hinges on their ineligibility for the dividends-received deduction. This deduction serves as a buffer against triple taxation—a scenario where the same income is taxed thrice: first at the company paying the dividend, then at the recipient company, and finally when the ultimate shareholder pockets the dividend.

Unpacking the Tax Implications of Preferred Securities

It's crucial to understand that the IRS doesn't paint all preferred securities with the same tax brush. Many preferred dividends are considered qualified and enjoy a lower tax rate compared to regular income. This makes them an attractive option for risk-averse investors seeking a balanced blend of stability and income.

The Evolution of Taxable Preferred Securities

The landscape of taxable preferred securities has undergone significant evolution since its emergence in the mid-1990s. The increasing popularity of these securities led to the creation of specialized funds and ETFs tailored to cater to investors' growing appetite for them. Despite their tax implications, the allure of higher yields has made taxable preferred securities a staple in many investors' portfolios.