I was new to Preferred Stock Investing over two years ago and would like to share my experiences and my mistakes. I had just retired at 56 with my wife and we hoped to live on our after tax money until we could or would have to tap into our tax sheltered accounts. In the current relatively low interest rate environment, I was looking for a way to generate income with a better return than tax free bonds with some tax advantage. Preferred Stocks seemed to have the same tax advantage as capital gains. If your income is below a certain limit the dividends from Preferred Stocks can be tax free. At the very least, dividends from certain preferred stocks have a lower tax rate than normal income. For corporate bonds on the other hand, the interest is taxed at the same rate as normal income. It seemed to me that preferred stocks were a better option with good returns and lower to no taxes on those returns.
I started looking for preferred stocks to invest. I searched the internet and found various lists including one on my broker's site. Wanting to make as much as possible I looked for companies I knew that were paying a good return. I purchased several of these and started doing more research on dividends and taxes. This is where I found my first mistake.
To be treated the same as capital gains, dividends from preferred stocks have to be qualified dividends. These are from normal domestic corporations not Limited Partnerships (LP) or Real Estate Investment Trusts (REIT). I had bought preferred stock from a Limited Partnership so I ended up selling those shares at or about the same price I paid for them, wasting my time and money. So if you are buying preferred stock for the tax advantage be sure it has fully qualified dividends.
Let's talk price and its impact on return. Most preferred stock is sold with a redemption price of $25 per share. Some are sold at $50, $100 or even $1000 a share but those are exceptions. Let's stick with $25 stocks for this discussion. The price you pay is set by the market. For a preferred stock that has been around for some time the price may be higher than $25 or possibly lower than $25. An example would be BANK OF AMERICA CORPORATION 6% Preferred Series EE. At a price of $26.20 per share, it is $1.20 above the redemption price. It pays 6% a year in qualified dividends on the $25 redemption price. This is $1.50 per year. If we divide this by the current price we get a return of 5.723% a year. Bank of America could redeem these shares at $25 on 4/25/2021. It is possible that you would only receive 2 years of dividends before they redeem the stock. If we take the $0.60 (1.20/2) from the yearly dividend, then you may only receive 90 cents a share. This figure takes the loss at redemption into account. 90 cents divided by the purchase price of $26.20 would yield 3.44% return. Bank of America may or may not redeem the stock in 2021, so the longer they wait before redeeming the shares the real return starts to approach the 5.723% rate. This brings me to my second mistake of not looking at the possible redemption date.
I purchased a preferred stock at around $26 a share and less than a year later it was redeemed. The dividends I was paid almost made up the difference between the redemption price of $25 and the price I paid. Again, it was a waste of time and money. Be careful what you pay for a preferred stock in relation to its current return and the impact of a possible redemption.
I plan to update this blog once a month or more with more information on investing in preferred stocks so look back in the future.
