Dividends vs capital gains represent two distinct ways that investors can see returns from their investments. Dividends are periodic payments made by companies to shareholders, often distributed in cash as a share of profits. In contrast, capital gains occur when an investor sells an asset, such as stocks or real estate, for more than the initial purchase price, resulting in a profit. Understanding the nuances of dividends vs. capital gains can help investors decide how best to approach their investment strategies, especially when considering tax implications and long-term financial goals.
Consider working with a financial advisor to weigh the pros and cons of focusing on dividends or capital appreciation.
What Are Dividends?
Dividends are distributions that companies provide to their shareholders, generally as a share of the company’s earnings. While these distributions are often given in cash, they may also be offered as extra shares of stock or other types of assets. Dividends are most commonly associated with well-established companies that generate consistent profits and wish to share a portion of these earnings with their investors. By distributing dividends, companies provide a direct way for shareholders to benefit from their ongoing financial success.
Dividends can be paid on a regular basis, such as quarterly or annually, and the decision to pay them is made by the company’s board of directors. The payout amount per share is often referred to as the dividend rate, which can vary depending on the company’s profitability, financial health and overall strategy. While some companies choose to reinvest profits into growth initiatives, others use dividends to attract and reward loyal shareholders. Investors who prioritize steady income may favor dividend-paying stocks, as they can provide a reliable revenue stream regardless of market conditions.
Not all stocks pay dividends. For example, growth stocks typically don’t pay dividends. Those companies typically reinvest profits into continued growth. A established brand’s blue-chip stock, on the other hand, may pay significant dividends.
Aside from stocks, some mutual funds also make dividend distributions. These dividends represent the total earnings across all of the underlying companies within the fund. A real estate investment trust (REIT) must pay out 90% of earnings to shareholders in dividends.
What Are Capital Gains?
Capital gains refer to the profit that investors realize when they sell an asset for more than its purchase price. This profit can result from the appreciation in value of a wide range of assets, including stocks, bonds, real estate or even collectibles.
The value of capital gains is directly tied to market conditions and the performance of the specific asset. Unlike dividends, which may provide regular income, capital gains are realized only when an asset is sold. Investors seeking capital gains often focus on assets that have strong growth potential, aiming to buy low and sell high. Timing plays a crucial role in capital gains strategies, as market fluctuations can significantly impact the potential profit. Understanding how capital gains work allows investors to strategically plan their buying and selling decisions to maximize returns while considering tax consequences and market dynamics.
Dividends vs. Capital Gains: Taxation
Both dividends and capital gains come with tax implication. However, specific rules apply to each of them. Let’s look at dividends first.
Qualified vs. Non-Qualified Dividends
Dividends aren’t all the same, though. Dividends are divided into qualified or non-qualified categories. Dividend-paying stocks or mutual funds most often pay qualified dividends. These dividends face the long-term capital gains tax rate.
The capital gains tax rate you pay on qualified dividends depends on your filing status and household income. For 2020, taxpayers will pay 0%, 15% or 20% for long-term capital gains tax. Some high-income taxpayers will also pay a 3.8% net investment income surtax on dividend income.
Non-qualified or ordinary dividends come from sources other than stocks. For example, savings accounts, money market accounts, certificates of deposit, and REITs pay non-qualified dividends. The IRS taxes thos dividends at your marginal tax rate. In other words, they fall into the highest tax bracket available based on your income.
Of the two, qualified dividends typically offer investors a move favorable tax option. If you’re a high-income earner, you’re likely to owe less in taxes even at the maximum capital gains tax rate than you would if you were taxed at your marginal tax rate.
Short-Term vs. Long-Term Capital Gains
If you have capital gains from the sale of a stock or another investment, their taxes depend on how long you held the investment. The short-term capital gains tax rate applies to investments owned for less than one year. This tax rate is the same as your ordinary income tax rate. In other words, short-term capital gains face the same taxes as money earned from your job or self-employment.
The long-term capital gains tax rate is more favorable and it kicks in when you sell an investment that you’ve owned for one year or longer. These are the same rates that apply to qualified dividends: 0%, 15% and 20%. Again, the rate you pay depends on your filing status and household income. Running the numbers through a capital gains tax calculator can help you estimate how much tax you’ll owe before selling a stock.
Managing Tax Liability on Investment Income
Keeping your bill to a minimum when you’re receiving dividends or realizing capital gains all comes down to strategy and knowing what you own. For example, you might assume that by reinvesting your dividends into additional shares of the same stock you can escape paying income tax on the distributions since you’re not receiving any cash. But the IRS still considers that to be taxable income for the year, which means it needs to be reported on your tax return.
With capital gains, there is one tactic you can employ that could potentially minimize what you owe in taxes. It’s called tax-loss harvesting. It involves selling off stocks that have lost money during the year to offset the gains realized by another stock in your portfolio. The key is avoiding the wash-sale rule.
This IRS rule says that you can’t sell shares of one stock and buy shares of a substantially similar one within 30 days before or after the sale date. If the IRS determines that you’ve done so, this effectively cancels out your ability to offset any capital gains by harvesting losses. This rule is designed to keep investors from gaming the system and dodging their tax liability for capital gains.
Bottom Line
There are subtle differences between dividends vs. capital gains, especially where taxes are concerned. The good news is you don’t have to choose between one or the other for investing. It’s possible to include both in your portfolio, although whether you should do so depends largely on your goals. The most important thing to keep in mind with either one is what investment growth could mean for you at tax time.
Investment Tips
- Consider talking to a financial advisor about large sales of stock. They can point out the tax implication of any potential capital gains. An advisor can help you devise a strategy for minimizing taxes owed as much as possible. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re thinking about adding dividend stocks to your portfolio, take time to research the stock carefully. Specifically, don’t simply focus on finding stock with for a high dividend yield. That alone may not paint an accurate picture of the stock’s potential. Instead, look at the company’s fundamentals and determine how dividend payouts change over time. That may indicate a company’s financially stability. Also, it may illustrate long-term dividend potential.
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