What Is a Preferred Dividend and How Does It Work?

Companies distribute a portion of their profits to shareholders as dividends, typically from retained earnings or current profits. Dividends are a way for companies to share their earnings directly with investors. While some companies reinvest earnings for growth, others provide regular dividend payments. These payments offer investors a consistent income stream, complementing potential stock price appreciation.

Preferred Stock and Its Dividend Fundamentals

Preferred stock is a distinct class of ownership, differing from common stock, especially regarding dividends. Preferred stockholders have a higher claim on a company’s assets and earnings than common stockholders. They receive dividends before any distributions to common shareholders. The “preferred” designation signifies this priority in receiving dividend payments.

Preferred stock has a fixed dividend rate. Unlike common stock dividends, which fluctuate with profitability, preferred dividends pay a fixed amount or percentage of the stock’s par value. For example, a preferred stock with a $100 par value and a 5% dividend rate would pay $5 annually per share, providing a predictable income stream.

Preferred stock generally does not carry voting rights, unlike common stock. Preferred shareholders forgo voting power in exchange for dividend stability and priority. This trade-off appeals to investors focused on income over corporate governance.

Therefore, a preferred dividend is the regular, fixed payment made to preferred shareholders, which takes precedence over any dividends paid to common stockholders. This payment structure positions preferred stock as a hybrid security, combining features of both equity and debt. The consistent nature of these payments and their priority in the capital structure make preferred dividends a notable feature in financial markets.

Key Characteristics of Preferred Dividends

Preferred dividends can possess additional features that significantly impact their payment terms: specifically whether they are cumulative or non-cumulative, and participating or non-participating. These characteristics determine how missed payments are handled and if shareholders receive distributions beyond the fixed rate. Understanding these distinctions is important for assessing preferred stock.

Cumulative preferred dividends ensure that any missed payments accumulate as “dividends in arrears.” A company must pay all accumulated missed dividends to cumulative preferred shareholders before distributing any dividends to common shareholders. This feature provides stronger assurance of eventual payment, even during temporary financial difficulties.

Non-cumulative preferred dividends do not accumulate if missed. If a company skips a payment, it is lost and does not need to be paid later. Non-cumulative preferred shareholders have no claim to past missed dividends before common shareholders receive distributions. This structure places more risk on the investor.

Participating preferred dividends allow shareholders to receive additional dividends beyond their fixed rate. This occurs if company performance thresholds are met or common dividends exceed a specified level. These shareholders “participate” in extra profits, often receiving an additional share of earnings alongside common stockholders after their fixed dividend. This less common feature offers an opportunity for increased returns.

Non-participating preferred dividends are limited to their fixed rate. These shareholders receive no additional distributions, regardless of company profitability or common dividend payments. This characteristic ensures a predictable, capped income stream. Most publicly issued preferred stocks are non-participating, meaning their dividend income is confined to the fixed amount.

Payment and Taxation of Preferred Dividends

The payment of preferred dividends follows a structured process, and their taxation for investors involves specific classifications. Companies adhere to a dividend distribution timeline, and the Internal Revenue Service (IRS) categorizes these payments in ways that affect an investor’s tax liability. Understanding these mechanics is crucial for managing income from preferred stock.

A company’s board of directors declares the dividend, specifying the amount per share, record date, and payment date. The record date is when an investor must be listed as a shareholder to receive the dividend. To be included, investors typically purchase the stock before the ex-dividend date, usually one to two business days prior to the record date.

Following the record date, the payment date is when the declared dividend is distributed to eligible shareholders. Dividends are commonly paid out as cash, often directly deposited into an investor’s brokerage account or sent via check. Many brokerage firms also offer dividend reinvestment plans (DRIPs), allowing investors to use their dividend payments to automatically purchase more shares of the same stock.

Preferred dividends are generally taxable income for individual investors. Tax treatment depends on whether the IRS classifies them as “qualified” or “non-qualified.” Qualified dividends are taxed at lower long-term capital gains rates (0-20%, depending on income bracket). To qualify, dividends must usually be from a U.S. corporation or eligible foreign entity, and the stock held for over 60 days during a 121-day period around the ex-dividend date.

Non-qualified dividends, or ordinary dividends, are taxed at an investor’s regular income tax rates, potentially up to 37%. Dividends not meeting qualified status criteria, such as those from certain REITs or failing the holding period, are taxed as non-qualified. Investors receive Form 1099-DIV from their brokerage, detailing total dividends and any qualified portion.