Many investors love the Federally tax-free income they receive from municipal bonds. Municipal bonds are debt securities issued by state and local governments to fund operations or special projects. Because the income an investor receives is not taxed, the after-tax return of municipal debt is often higher than the after-tax income provided by corporate bonds and bank CDs.
For example, the yield on the iShares Core US Aggregate Bond ETF (AGG) currently stands at about 2.73%. For a taxpayer subject to a 22% marginal income tax rate, the after-tax return drops to just 2.1% and is even lower as you climb into higher marginal tax brackets. Compare this to the Vanguard Tax-Exempt Bond Index Fund ETF (VTEB) which yields 2.28% federally income tax free.
An often-underappreciated item in the US income tax code deals with qualified dividends. A qualified dividend is a dividend from a common stock or a preferred stock that the filer owns for a specified minimum time period. The beauty of qualified dividends is that they are taxed at the filer's long-term capital gains rate rather than as ordinary income. The following table compares ordinary income rates and long-term capital gains rates for married filing jointly returns.
Capital gains rates are not perfectly aligned with the marginal tax rates due to the Tax Cut and Jobs Act of 2017, but except for a small slice of taxable income between $78,751 and $78,950 (2019), the tax rate on long term capital gains is lower that the tax rates on other forms of taxable income.
Which brings us to the value of qualified dividend income (QDI). QDI extends to income received from preferred securities. Preferred stocks are debt-like securities issued by corporations that rank below the bond holders-- but above the stockholders-- in the event of a liquidation. The term preferred is used because the dividends on these shares must be paid in preference to dividends paid to common stock shareholders. To learn more about preferred stocks you can view the Wikipedia entry here.
The importance of this is the after-tax returns of many preferred securities held long enough to receive QDI tax treatment, are higher than rates generally available in the municipal bond market. Take the Goldman Sachs preferred A shares (GSPRA) for example. This security has a current dividend yield of 4.7%, even at the highest capital gain rate of 20% the after-tax net on this income is 3.7% or 60% more than the tax-free rate of 2.3% from VTEB.
There are some details to keep in mind; to qualify for QDI status, the security must be held for 91 days out of the 181-day period, beginning 90 days before the ex-dividend date. Because most preferred securities pay quarterly dividends, you would generally need to make your purchase the day of the preferred trade’s ex-dividend to ensure you receive favorable tax treatment.
Also, preferred issues are highly concentrated in the financial and utility sectors of the market which could lead to poor diversification. You could use exchange traded funds (ETFs) like the iShares Preferred and Income Securities ETF (PFF) or an open-end mutual fund like the Nuveen Preferred Securities and Income Fund; but be aware that not all the distributions from funds like these are considered Qualified Dividend Income. Only 62% of the distributions from PFF were eligible for QDI treatment in 2018 and usually about 60% of the Nuveen funds distributions were QDI eligible.
Still, for investors concerned with building a tax-efficient portfolio, preferred securities are certainly worth consideration.