Dividends 101: What Are Qualified & Preferred Dividends

The term dividend is derived from the Latin word “dividendum”. It means “the thing to be divided”. In simpler and more direct terms, a dividend is a way for companies to split their profits among the shareholders. The tradition of companies paying out dividends to its shareholders is over 400 years old. The first company to do so was the Dutch East India Company during the early 17th century. Since 1929, dividends have made up over 40% of all the returns in the S&P 500. Dividends are a great tool for companies to attract investors to purchase their stock. The money raised by that is then used to fund the firm’s operations and business expansion. All companies don’t pay dividends though. The ones that pay can also change their policy at any given time. But returns hungry investors have led to more and more companies offering dividends as a benefit for people investing in their stocks. Many companies have also raised their existing dividend amounts. In this post, we will take a brief look at the different types of dividends and find out what are qualified and preferred dividends as well. Let’s get started.

The Basics of Dividends, Qualified Dividends and Preferred Dividends

What is a dividend?

A dividend is a cash payment made by a company to the holders of the company’s stock. There are a few different types of dividends, some of them don’t even involve cash payment to shareholders.

What are the different types of dividends?

• Cash dividend

This is by far the most prevalent type of dividend. On the day of dividend’s declaration, the company’s board of directors promises to pay a certain amount as cash dividends to the investors holding the company’s stock on a specific date. The date of record is the date on which the dividends were assigned to the company’s stock holders.

• Stock dividend

A stock dividend is an issuance of a company’s common stock to its common shareholders without any extra consideration. If less than 25 percent of the total number of previously outstanding shares are issued, the transaction is considered a stock dividend. If the transaction is for a greater proportion of the previously outstanding shares, then the entire transaction is considered a stock split. The fair value of the additional shares issued depends on the fair market value of those specific shares on the day of the dividend’s declaration.

• Property dividend

A company can also choose to issue dividends that don’t have to be monetary like cash or stock payment. This distribution is recorded at the fair market value of the distributed assets. Firms can also use property dividends to make changes to their taxable income.

• Scrip dividend

In case a firm lacks the funds required to issue dividends, it can issue scrip dividends which can serve as promissory notes (at times, they can bear interest as well) which will pay the shareholders at a later date.

• Liquidating dividend

In case the board of directors decides to return all of the capital originally invested by the shareholders in the form of a dividend, it’s known as a liquidating dividend. Unfortunately, this also heralds the looming closure of the company. Liquidating dividends are accounted in the same way as cash dividends. However, the funds are considered to be channeled from the additional paid-in capital account.

What are Qualified Dividends?

A qualified dividend is a dividend that qualifies for capital gains tax rates that are lower than the tax rates on ordinary/qualified dividends. Ordinary dividends are taxed at the same rate as the  standard federal income tax rates, or 10% to 37% for tax year 2020. By way of comparison, qualified dividends are taxed as capital gains with the rates oscillating between 20%,15% or 5% depending on the individual’s tax brackets. This difference in rates can create a huge difference in the amount of tax levied on ordinary and qualified dividends.

Ordinary Vs. Qualified Dividends

Qualified and unqualified dividends definitely have some differences, however minor they might seem to be. However, those differences can have a profound impact on total returns. In general, most of the dividends issued by American firms fall in the qualified category. The biggest difference between qualified and unqualified dividends is definitely the income tax rates that are levied on them. Unqualified/ordinary dividends are taxed based on an individual’s normal income tax rate while qualified dividends are taxed on preferred rates. So regardless of tax brackets, people can see a massive difference in their income tax payouts, regardless of the tax bracket they fall in.

What are Prefered Dividends?

Preferred dividends are cash distributions that are dispersed among the people who own a firm’s preferred shares.

Most large firms tend to have multiple classes of stocks. Two of the most common ones are preferred shares and common shares. While common shareholders hold voting rights that preferred shareholders don’t, there are some distinct advantages of being a preferred shareholder despite that. Most large corporations have multiple classes of stock. Preferred Shareholders generally tend to get guarantee dividend payments at rates higher than common shareholders. This means that preferred shareholders can expect dividends on a regular basis. That will definitely add up to a significant difference in the long run. In case the company’s board doesn’t declare any dividends in a given period, the guaranteed payments for this period are put into arrears which will be paid out later to the preferred shareholders. This is kind of like a liability account that the company puts on its books notifying that it owes money to the preferred shareholders. Once the board releases the dividends, the preferred shareholders’ arrear balance must be cleared before the current dividend is paid out.

So that was a brief glimpse into the wonderful world of dividends. Hopefully, you have got a basic idea of dividends, their types, and what are qualified and preferred dividends. Use this knowledge to boost your stock market trading skills and start reaping returns.