Dividends and capital gains represent investment income. Both types of income increase the investor’s wealth. But the tax implications of receiving them may differ. The advantages and disadvantages of both options must be known in order to choose the right strategy to grow your personal finances.
Table of Contents
Dividends Defined?
Dividends are the share of a company’s profits it distributes to stockholders. Exchange-traded funds and mutual funds also pay dividends. In such a case, money received from issuers of securities that are part of the net assets is used.
More often the payments are quarterly. But they can be semi-annual or annual. You can receive dividends once a month from some REITs and ETFs.
Not all stocks pay dividends. Typically, profits are divided among shareholders by large businesses that have completed the phase of active development. Growth companies invest free funds in expanding existing production or creating new ones.
Payments from mutual funds are not always dividends. Such management companies are obliged to divide among investors the profits received from the sale of securities. Comparing capital gains distributions vs dividends in terms of tax burden is a reason to abandon investments in mutual funds in favor of ETFs. Such income is considered to be short-term and therefore carries a higher tax liability.
To receive dividends, you must own the stock before the ex-dividend date. Payments can be in the form of property, for example, by issuing additional stocks. But more often dividends are distributed in the form of cash.
Types of Dividends: Qualified & Non-Qualified Dividends
In the US, dividends are divided into 2 types – qualified and non-qualified. The former gives an advantage in terms of tax rates.
In order for dividends to be recognised as qualified dividends, a number of conditions must be met:
- the payor is a U.S. company (excluding REITs and MLPs) or an eligible foreign corporation;
- the investor has held the stock for the period of time required (for common stock, more than 60 days);
- the brokerage account into which the dividends are received does not provide other benefits (investing in traditional retirement plans does not allow for dividend tax reduction).
Distributions on stocks that do not qualify will be considered ordinary dividends.
Capital Gains
Capital gain, or investor’s profit, is the benefit received from the sale of a capital asset, i.e. an increase in its value relative to the purchase price. Capital assets are defined as significant items of property – stocks, real estate, etc.
Until a person has sold the asset, all price changes are “paper” gains or losses. They do not affect the amount of tax.
Here is an example of how an investor’s profit is calculated:
- A person bought 200 stocks at $100, paying $20000 in total.
- After a while this person sold them for $125 per stock, i.e. for $25000.
- The profit will be $25000 – $20000, which equals $5000.
In reality, income may be lower due to transaction fees. These costs are recognised in the capital asset value and reduce the amount subject to tax.
Types of Capital Gains: Short-Term & Long-Term
In the US, income is divided into 2 types. The classification is based on the period of ownership of the asset, upon the sale of which the profit was received:
- more than a year – long term capital gain;
- less than a year – short term capital gain.
Profit can also be realized on a short sale. The category into which it is categorized depends on whether the transaction was covered or uncovered and some other factors.
Capital Gains vs. Dividend Income: An Overview
Dividends and capital gains are income to the investor. Their receipt gives rise to tax liabilities.
Here are the key points in comparing capital gains vs dividends:
- Assets have to be constantly sold and bought to generate cash flow from asset transactions. Dividends are completely passive income.
- The tax saving holding periods for a stock are noticeably shorter in the case of dividend income than for capital gains on sale.
- An investor following a dividend strategy must pay tax annually ( retirement plans excluded). One who invests in growth stocks – only in the year of profit taking. For a while, their capital grows tax-free.
There are some similarities between the 2 types of income. For example, a person can reinvest dividends and capital gains. Both actions will increase the value of the portfolio.
Dividend Income
The amount of dividend income depends on many factors. The key ones are:
- dividend policy, based on which the board of directors determines the payout;
- the company’s net income;
- the number of stocks held by the investor.
As an example, an investor owns 100 stocks in company N, which pays a quarterly dividend of $1. Every 3 months, they receive a dividend income of $100. For the year, the dividend yield is $400.
The current dividend yield is defined as the percentage of the payout value to the stock’s value on the record date. Say, for example, the stock of a company that pays $1 is worth $100. The current yield is 1%. When the payout is quarterly, the annual rate is 4%.
Dividends vs. Capital Gains: Tax rate
The main aspect of the capital gains vs dividends comparison is the tax burden. There are 2 types of rates in the US – on long term capital gains and on ordinary income. The maximum individual rate depends on several factors:
- type of taxable income;
- the investor’s total annual income;
- filing status.
Dividend taxes
Qualified are dividends capital gains at 0%, 15% or 20%. When the ordinary dividends are considered ordinary dividends, the tax is calculated at the rate applicable to ordinary income (10% to 37%).
The amount of qualified dividends is reported in Section 1b of Form 1099 provided by the broker. To determine how much tax to pay on ordinary income, you must make your own calculation. From the amount shown in section 1a of Form 1099, subtract the number in box 1b.
Capital gains taxes
When the asset has been owned by the investor for more than a year, capital gains tax rates are used. Less than a year is the ordinary income tax rate. But there are a few exceptions, such as luxury goods and collectibles, for which different rates apply.
Tax must be paid at the end of the year on net capital gains. I.e. profits and losses from securities transactions are summed up. When the result is a positive value, tax is taken on it. When it is negative, this amount can be used to reduce other types of taxable income (but not more than $3000 per year).
Not only the federal government can tax capital gains, but also individual states, such as California.
Managing Tax Liability on Investment Income
Reducing tax liabilities is one of the effective ways to increase the return on investment. That is why the strategy of “loss harvesting” was invented. The essence of the strategy is that an investor sells stocks that have fallen in price in order to “compensate” for the profits made on other positions.
When resorting to this strategy, you should remember several crucial points:
- Losses from assets that have been held by the investor for more than a year first “cover” long-term income. When there is still a ” negative ” after that, it can be transferred to short-term income. The same is true for short-term losses.
- Securities (or identical securities) sold to lock in a loss can be repurchased no sooner than 30 days later.
- An investor must buy the asset on which they recorded a loss no later than 30 days before the sale.
When a person has violated the wash-sale rule, they will not be able to take advantage of the benefit and offset the resulting loss to reduce the tax base.
A more effective way to reduce tax on income from trading assets is to hold them for a long period of time. It is most effective to sell them after retirement (or during the years of not having a steady job). A low-income person does not pay tax on long-term capital gains, since the rate for them is 0%.
Net investment income tax
The federal taxes discussed above are withheld from all investors. Additionally, there is a tax on net investment income in the United States. The obligation to pay it arises for people with high modified adjusted gross income. The latter must exceed $250 thousand for a married couple and $200 thousand for a non-married person.
The tax rate is 3.8 per cent. It is withheld on both dividends and profits from transactions with assets, regardless of their qualification.
Tax-free capital gains and dividends
A universal way to completely avoid tax on investment income is through the use of tax advantaged trust accounts. The most popular types are the Roth 401 (k) and Roth IRA. Traditional retirement plans only allow you to defer the due date.
There is no way to avoid tax in standard accounts. Even when a person does not withdraw money, but reinvests capital gains and dividends. Only dividends from mutual and exchange-traded funds with net assets consisting of tax-exempt municipal bonds are tax-free.
Dividends vs capital gains which is better: Pros and Cons of Investing in either Type
A comparison of dividends versus capital gains in terms of the advantages and disadvantages of each type of income is summarized in the table below.
| Dividends | Income from transactions | |
| Advantages | Fully passive and more stable income.To reduce tax, it is enough to hold the asset for 60 days | The investor chooses when to lock in profits. By managing the date of the asset sale, they can reduce the tax |
| Disadvantages | There are less chances to avoid paying taxes.There is a risk for the company to refuse payments | To reduce the tax, you need to own the asset for more than a year.Quotes are volatile, an investor may not get the expected profit.In order to get income, you need to be active |
The Future Outlook for Both Types of Investments
When comparing dividends vs capital gains, it should be noted that both types of investment income are attractive in the long term. Dividends imply regular and stable income. An investor who has once built an effective dividend portfolio does not need to put in extra effort to make money.
When an investor bets on growth stocks that will not be sold for years to come, they do not have a steady cash flow. Moreover, they will have no tax liability. But there’s no guarantee that the quotes won’t fall years later and the person will receive the planned income.
But in the long run, profits from growth stocks can be hundreds of per cent of the initial sum invested. Dividends will not give quick enrichment. The average dividend yield of the S&P 500 index is less than 2 percent. Individual REIT funds can yield 10-12% per year.
The Bottom Line: Key Takeaways
The key ideas of capital gains vs dividends comparison to remember:
- Dividends are important for investors who want to receive a stable cash flow now.
- Income from a price rise is only taxable once the gain has been recognised. This gives room for tax optimisation.
- The rate at which dividends are taxed as capital gains depends on the holding period of the assets that brought them in. It also depends on the investor’s total income and the type of asset.
FAQ
H3 Is it better to have dividends or capital gains?
The choice of capital gains vs dividends depends on the investor’s goals. For an individual looking for passive income, a dividend strategy is better. For one who is ready to constantly analyze the market and has the knowledge to do so, betting on growth stocks can bring greater profits.
Do dividends count as capital gains?
The answer to the question of whether they are dividends considered capital gains is yes. When dividends fall into the qualified category, they are taxed at the appropriate rates.
Why do investors prefer dividends over capital gains?
The main argument in comparing capital gains vs dividends is that dividends are a source of passive income. Their receipt does not require any effort. And owning stocks of dividend aristocrats brings a more stable profit than trying to beat the market.
H3 How do you avoid capital gains tax on dividends?
The universal way is to use Roth IRA and Roth 401 (k) accounts. They exempt dividend income and gains on the sale of assets from tax. When dividends are capital gains, i.e., classified as qualified dividends, a person with income below $44,625 may not pay tax on them in 2023.
