Over the next several months we are going to hear quite a bit about whether or not dividends, including some preferred stock dividends, should continue to be taxed at a lower rate than regular income.

Since preferred stock investors invest for dividend income, one is tempted to think that proposals to raise the tax rate on such income would be detrimental to such investors. And, to a limited extent, it would be. But as I am about to explain, for the most part, ending the favorable tax treatment that is applied to the dividends generated by a select group of 255 preferred stocks [1] is largely irrelevant to risk-averse preferred stock investors.

One of the objectives of the Tax Reform Act of 2003 (officially called The Jobs and Growth Tax Relief Reconciliation Act of 2003) was to provide an incentive to investors. Prior to the Act, most dividend income was taxed at higher regular income tax rates. The Act authorized a new dividend tax rate capped at 15%.

Sounds great. But by the time a risk-averse preferred stock investor applies the law to the preferred stocks trading on U.S. stock exchanges, it is not as clear that the Act is as effective as was once hoped. Only 255 out of these 1,000+ preferreds qualify for the 15% tax treatment under the Act.

Risk-Averse Preferred Stock Investors

Preferred stocks offer investors a menu of characteristics. By picking from these characteristics, preferred stock investors can lower their risk profile substantially.

For example, risk-averse preferred stock investors tend to seek preferred stocks that (A) have an investment grade rating (as opposed to speculative grade) and (B) offer the ‘cumulative’ dividend feature (if the issuing company skips a dividend to you they still owe you the money; their obligation to you accumulates). Such preferred stocks offer what is arguably a lower investment risk than preferred stocks without such characteristics.

So what do the 255 tax-advantaged preferred stocks have to offer risk-averse preferred stock investors?

255 Becomes 10

In Steve Martin’s 1979 comedy classic The Jerk, Steve plays the part of the guy at the carnival who guesses people’s weight. One passer-by, looking at the massive rack of prizes, asks what he will win if Steve fails to guess his weight correctly. Starting at the top, Steve gradually narrows down what at first seemed like a selection of great prizes to a choice of pencils.

The Tax Reform Act of 2003 offered preferred stock investors a break on their taxes (massive rack of prizes), but watch what happens when we tally up what is actually available to risk-averse preferred stock investors (choice of pencils).

Since January 1, 2004 (the era of the Act) there have been 255 preferred stocks issued that qualify for the Act’s 15% dividend tax treatment. The following table applies the risk lowering characteristics that most preferred stock investors favor to these 255 tax-advantaged preferred stocks [2] :

Limiting the list to those preferred stocks with investment grade ratings and cumulative dividends drops the list from 255 to just 76. And removing Nuveen’s municipal bond-backed securities (with their average annual yield of 2.5%) and foreign issues (Netherlands, UK, Bermuda) leaves us with just ten to pick from [3] .

Even though 255 tax-advantaged preferred stocks have been issued since January 1, 2004, risk-averse preferred stock investors are unlikely to invest in at least 245 of them.

79 High Quality Preferreds Have More To Offer

The above table identifies the ten preferred stocks that not only offer the risk lowering characteristics that many preferred stock investors seek, but also qualify for the Act’s 15% dividend tax treatment.

But check out the dividend yield and price columns. The Market has priced these ten preferred stocks such that any tax benefit is eliminated by the below average yields from these ten tax-advantaged securities. The current average annual dividend yield offered by high quality [4] preferred stocks is 6.9% compared to the 5.6% average from these ten tax-advantaged issues.

Also, these ten are all trading well above their respective par values, meaning that in the event that the issuing company retires the shares, the investor would realize a capital loss, further eroding one’s return.

While the ten tax-advantaged preferred stocks listed in the above table offer the special 15% tax treatment to risk-averse preferred stock investors, you give up about 19% of your dividend return (6.9% versus 5.6%) and expose yourself to a capital loss in order to receive that tax break.

As an alternative to these tax-advantaged preferred stocks, there are currently 79 high quality preferred stocks trading on U.S. stock exchanges. These 79 high quality preferreds offer what is arguably the lowest risk profile to today’s preferred stock investor and, ironically, a higher after-tax return.

While the debate whether or not to eliminate the 15% tax rate for preferred stock dividends may seem concerning, it is not clear that tax-advantaged preferred stocks offer any advantage to today’s risk-averse preferred stock investors whatsoever. Even though dividends from the 79 high quality preferred stocks trading on U.S. stock exchanges are taxable as regular income, the risk-lowering characteristics, increased diversification and higher average annual dividend yield that they offer appear to be substantially more beneficial to risk-averse preferred stock investors than tax-advantaged issues.

Footnotes:

[1] As of February 13, 2012. Data sources for tax-advantaged preferred stocks: CDx3 Notification Service database, see PreferredStockInvesting.com ; QuantumOnline.com, U.S. Securities Exchange Commission at SEC.gov. Disclaimer: The CDx3 Notification Service is my preferred stock email alert and research newsletter service.

[2] Yields based on February 13, 2012 market prices. Nuveen packages municipal bonds into a fund and then offers investors shares of preferred stock in the fund. These 55 municipal bond-backed funds are not included here since their dividend rates are based on the underlying bond and average 2.5% as of February 13, 2012. The foreign issues that have been omitted are offered by AEGON NV, Netherlands (NYSE:AEG ); HSBC Holdings plc, UK (HBC); PartnerRe, Bermuda (NYSE:PRE ); Prudential plc, UK (NYSE:PUK ) and RenaissanceRe Holdings, Bermuda (NYSE:RNR ). It is not clear why the Act provides a tax break for investing in foreign-issued securities. SCEDP trades on the Over-The-Counter stock exchange while all others seen here trade on the New York Stock Exchange.

[3] See Seeking Alpha’s Preferred Stock Trading Symbol Cross-Reference Table to see how your online service denotes preferred stock trading symbols. Source for second table: preferred stock data is from the CDx3 Notification Service database, February 13, 2012.

[4] High quality preferred stocks are those that meet the ten risk-lowering selection criteria from chapter 7 of my book, Preferred Stock Investing. For example, high quality preferred stocks offer cumulative dividends (if the issuing company skips a dividend payment to you they still owe you the money; their obligation to you accumulates), are rated as investment grade and are issued by a company that has a perfect track record of never having suspended a preferred stock dividend. For more about how to select, buy and sell the highest quality preferred stocks read my October 24, 2011 Seeking Alpha article titled Preferred Stock Investing: A Simple Guide To 7% Yield .

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.