Preferred Stock ETFs – High Dividends, Low Taxes?

Arden Dale covers preferred stocks in today’s WSJ personal finance section, noting that the combination of high yields and low taxes makes them a nice complement to municipal bonds.

Investors can use ETFs as a low cost, diversified way to take advantage of the yields that preferred stocks offer which currently hover around 7%. We first introduced preferred stock ETFs in an earlier post.

One of the key benefits of preferred shares examined by Dale is taxes – qualified dividends are taxed at a lower rate than ordinary dividends (see below for more on tax rates). The question for investors in preferred stock ETFs is this – how do you determine whether dividends paid out by the preferred stock ETFs are qualified or not?

For the iShares S&P Preferred Stock Index Fund (Amex: PFF), you can determine the percent of distributions that were eligible for qualified tax treatment from last year in the 2007 Distribution Summary Information document. For 2007, about 33% of PFF’s dividends were qualified. iShares does not provide guidance on the split between qualified and ordinary in the current tax year.

For more information on the iShares S&P Preferred Stock Index Fund, see the iShares website.

Tax Rates for Qualified Dividends

Dividends are taxed either as ordinary income or as qualified dividends. In order to be taxed as a qualified dividend, the investor “must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date,” as the IRS explains in Publication 550.

One change from 2007 when the tax rate on qualified dividends was 15% or 5% depending on your tax bracket. For 2008, the tax on qualified dividends for those in the lower tax bracket (below 25%) goes to 0%. See IRS pub 550 for more information.