Capital Gains vs Dividends: What is the Tax on Dividends? | 2025 Guide

Key takeaways:

Investment income comprises a dividend and a capital gain.
Dividends are regular payments made to a company’s holders of its stock.
They are sourced from the company’s net profit.
Capital gain is a profit that arises from the difference between the sale price and the purchase price of an asset.
Both types of income have their own taxation features. These features must be understood and considered when planning an investment strategy.

This article will compare capital gains vs dividends, discussing how these components of income affect capital and the investor’s tax obligations.

Table of Contents

What Are Dividends?

Dividend payments are shareholder rewards for investments in a business. In most cases, they represent a distribution of a portion of the company’s profits.

Most companies whose stocks are traded on American exchanges pay dividends to shareholders on a quarterly basis. However, some securities have dividend payments that occur monthly, twice yearly, or yearly.

The frequency of dividend distributions is determined by the company’s dividend policy. This document also sets out the principles on which the board of directors bases its recommendations regarding payments to shareholders.

Investors can use dividend income as an alternative to active earnings. However, many prefer to reinvest the money paid to them in order to increase their capital.

How Dividends Are Paid

The payment schedule for companies and mutual funds comprises several key dates:

The declaration date is the day on which the amount of the upcoming dividend distribution is announced.
The record date is the day on which the company compiles the list of shareholders. In order to receive the dividend distribution, an investor must own the company’s stock on this date.
The ex-dividend date is defined as the first business day when a stock no longer entitles the buyer to receive the upcoming dividend.
The payment date is the date on which the company makes the dividend payout.

One of the key metrics for income investors is the payout ratio. This indicates the proportion of net income that was paid out as a dividend.

Note: Cash dividends are taxed in the year they are received. However, payments made into tax-advantaged accounts, such as retirement accounts, are exempt.

Types of Dividends

Cash dividends are divided into two types for tax purposes: qualified dividends and ordinary dividends.

Special dividends are classified as ordinary. However, only regular, recurring payments are considered qualified.

If a company pays stock dividends, the investor does not incur any tax implications in the year of receipt. Taxes on this type of income are only payable when the investor sells the company’s stock.

Assets can also be distributed to shareholders by the company, typically during liquidation.

What Are Capital Gains?

Capital gains refer to the profit made from the sale of assets when the sale price exceeds the original purchase price. In investing, there are two concepts: paper gains and realized gains. Paper gains refer to investment growth resulting from asset appreciation up to the point of sale. Realized gains are the actual income received by an investor at the time of sale.

Only realized gains are subject to income tax. Therefore, holding assets for the long term effectively provides tax-free capital growth.

Short-Term vs. Long-Term Capital Gains

For tax purposes, income from the sale of assets is categorised as either short-term or long-term. Which category the profit falls into depends on the asset duration.

Short-term capital gains refer to income generated from the sale of assets held for less than a year. These gains are taxed at ordinary income tax rates. Preferential rates apply to long-term capital gains if the investment timeline exceeds one year.

Calculating Capital Gains

Net capital gain is calculated based on the cost basis. For example:

an investor bought a stock for $100;
the sale price was $110;
the capital gain is $10 (excluding broker commissions).

This means that the investor must pay tax on $10. However, tax liabilities can be reduced through capital losses, which occur if the sale price of the asset is lower than its original purchase price.

Key Differences Between Dividends and Capital Gains

Both investment strategies for income generation can be aimed at increasing capital. Reinvestment is an important factor in building wealth. However, these approaches have fundamental differences. The main differences lie in investor control and tax payment timing.

Income Timing and Predictability

Dividends are regular payments that provide a relatively stable cash flow. However, these payments are not guaranteed. They can be reduced or cancelled if the company experiences financial difficulties. However, quality diversification can minimize the risk of passive income disappearing.

Profit from the sale of assets cannot be considered a predictable income source. This is because it depends on the economic situation. Additionally, this strategy requires investor involvement. Investors must have a good understanding of market timing strategies and know when to buy and sell.

Reinvestment Considerations

Dividend reinvestment is an investment strategy based on the principle of compounding growth. In this approach, received payments are used to purchase additional shares. This increases the investor’s assets and passive income. Over time, this causes the growth chart of their capital to approach an exponential curve.

The advantage lies in the ability to set up automatic reinvestment using DRIP. This eliminates the need for investors to monitor payment schedules.

Tax Treatment of Dividends

Dividend taxation optimization is an effective way to increase overall returns. Qualified dividends are taxed at long-term capital gains rates. Ordinary dividends, on the other hand, are taxed at income tax rates.

The individual income tax rate of each investor depends on the tax bracket they fall into. These brackets are determined by their total annual taxable income and filing status.

Qualified vs. Ordinary Dividends

A common question is, ‘Are dividends capital gains?’ Regular shareholder rewards do not fall under this type of investment income. However, they may be taxed at the same rates.

In order for a company’s payment to qualify as a qualified dividend, the following conditions must be met:

Payment type – regular.
Payer – domestic corporations or qualified foreign corporations.
For common stocks, the holding period requirement is at least 61 days within a 121-day period beginning 60 days before the ex-dividend date. For preferred stocks, these periods increase to 91 and 181 days respectively.

Another important factor in dividend classification is the absence of hedging. Investors lose tax benefits if they have used short sales, options or futures on the stock from which income was received.

In order for their distributions to be recognised as qualified, mutual funds must also meet all the listed requirements.

Any payments that do not meet these criteria are considered non-qualified, or ordinary. Distributions from pass-through companies, credit unions, money market funds and other similar organisations are always subject to ordinary income tax.

Dividend Tax Rates

The tables below show income thresholds depending on filing status.

The tax brackets for long-term capital gains for the 2025 tax year are demonstrated.

Qualified dividend tax rate 2025	Single	Married couples filing jointly	Married couples filing separately	Heads of household
0%	up to $48,350	up to $96,700	up to $48,350	up to $64,750
15%	$48,351 – $533,400	$96,701 – $600,050	$48,350 – $300,000	$64,751 – $566,700
20%	$533,401 and more	$600,051 and more	$300,001 and more	$566,701 and more

Ordinary income tax rates.

Tax rate	Single	Married filing jointly	Married filing separately	Head of household
10%	up to $11,925	up to $23,850	up to $11,925	up to $17,000
12%	$11,925 – $48,475	$23,850 – $96,950	$11,925 – $48,475	$17,000 – $64,850
22%	$48,475 – $103,350	$96,950 – $206,700	$48,475 – $103,350	$64,850 – $103,350
24%	$103,350 – $197,300	$206,700 – $394,600	$103,350 – $197,300	$103,350 – $197,300
32%	$197,300 – $250,525	$394,600 – $501,050	$197,300 – $250,525	$197,300 – $250,500
35%	$250,525 – $626,350	$501,050 – $751,600	$250,525 – $375,800	$250,500 – $626,350
37%	$626,350 and more	$751,600 and more	$375,800 and more	$626,350 and more

To show how crucial tax planning is, let’s look at the process of dividend tax calculation. Suppose a single investor has an annual income of $300,000. This income falls into the 15% and 35% tax brackets.

Additionally, the investor receives $10,000 in profits. If the dividend is recognized as qualified, they will need to pay $1,500 in income tax. Otherwise, the income tax will amount to $3,500. Consequently, they will lose $2,000 of investment income.

Tax Treatment of Capital Gains

Capital gains tax is determined by the holding period, tax bracket, and type of asset.

One way to reduce investment tax is to make a capital loss. Here is an example of profit taxation: suppose an investor sells shares in one company for $1,000 more than the original purchase price. Meanwhile, they sell shares in another company for $400 less than the purchase price. As a result, the amount on which they must pay tax will be $600.

Short-Term vs. Long-Term Capital Gains Tax Rates

Short-term ones are taxed at ordinary income rates, meaning a tax rate ranging from 10% to 37% on the profit. In contrast, long-term are taxed at preferential rates of 0%, 15% or 20%. The rate varies depending on the tax brackets.

When deciding when to sell an asset, it is important to consider not only price appreciation, but also tax planning. In order to qualify for lower rates, the asset must be held for more than a year.

Special Cases in Capital Gains Taxation

However, there are several exceptions to the above information. For instance, gains from the sale of real estate are regulated by Section 1250. If depreciation recapture has occurred, the tax rate is 25%. Income from the sale of collectibles, NFTs, small business stocks, and others is subject to a 28% tax rate.

High-income investors also pay an additional 3.8% net investment income tax. To trigger this tax liability, the MAGI must exceed $200,000 for a single investor or $250,000 for a married couple filing jointly.

Tax-Efficient Investing Strategies

Any portfolio management investment strategy should include tax planning. After-tax returns are directly impacted by tax efficiency.

Tax-Advantaged Accounts

The most effective way to optimize taxes is to leverage retirement planning benefits. Traditional IRA and 401(k) accounts offer tax-deferred growth until retirement. Roth accounts fully exempt investment income from taxes.

Tax-Loss Harvesting and Timing Strategies

Another optimization approach is to offset gains through tax-loss harvesting. In this strategy, the investor makes strategic selling to reduce taxable income for the current year. Another option is the capital loss carryover to future years.

Long-term capital gains are initially combined with long-term capital losses, while short-term capital gains are combined with short-term losses.

Another aspect of the tax-loss harvesting strategy is the timing of transactions, or the ‘quick sale’ rule. Buying the same stock, or options on it, within 30 days of the sale date will prevent taxes being reduced through loss harvesting.

Dividend Income vs. Capital Gains: Which Should You Prioritize?

When choosing between a capital gain and a dividend, it is important to consider investment goals and income needs.

For example, growth investing may be effective in the early stages of retirement planning. As you approach your financial goals, however, experts recommend shifting to a value investing strategy or selecting assets with fixed income.

Investor Life Stages and Income Needs

During the accumulation phase, investors can choose from two wealth building strategies. Once they have income needs, they transition into the distribution phase.

It is advisable to create a portfolio that generates regular payments for retirement income. This approach helps to avoid the need to sell assets during a bear market.

Building a Balanced Portfolio

Many investors do not make a definitive choice between dividends vs capital gains. They prefer a balanced approach. Their portfolio includes growth stocks and assets that generate passive income.

Such diversification simplifies risk management and sector allocation. During bear markets, investors have a steady source of funds with which to buy at attractive prices. In bull markets, their portfolio benefits from growth stocks, resulting in a higher total return.

Conclusion

Both dividends and capital gains can equally contribute towards achieving financial goals. However, investing in growth stocks requires greater involvement and a deeper understanding. In any case, all investor actions should be the result of informed decisions.

Regardless of the chosen approach, tax planning is an essential component of an investment strategy for building long-term wealth.

FAQ

Is it better to have dividends or capital gains?

Those with high earnings may wish to forgo income strategies in order to reduce their tax burden. In such cases, personal finance advisors recommend, at a minimum, avoiding payments that are classified as ordinary income. The best approach is to own growth stocks in the long term.

Is it better to reinvest dividends and capital gains?

Reinvestment provides the power of compounding. Over decades, this significantly increases the total return.

Do dividends reduce capital gains?

Typically, the capitalization of companies that pay to shareholders grows more slowly. Companies that reinvest all profits into development tend to show more significant stock price growth. However, this does not mean that an investor is guaranteed higher returns by forgoing regular income payments.

Article Sources

Johnson, M. T., & Harris, P. L. (2024). Investment Income Taxation: Capital Gains and Dividends Compared. Journal of Taxation Studies, 39(2), 183-201.
Zhang, W., & Peterson, A. (2023). Investor’s Guide to Tax-Efficient Portfolio Management: Choosing Between Capital Gains and Dividend Strategies. Financial Planning Review, 22(4), 415-432.
Blackwell, R. D., & Michaels, S. (2024). Financial Markets and Investment Decision Making: Tax Implications of Capital Appreciation versus Dividend Income. Oxford Finance Series.
Lee, J. H., & Morgan, K. T. (2023). Comprehensive Tax Planning for Individual Investors: Understanding Income Characterization and Its Impact. Tax Planning Quarterly, 18(3), 67-89.
Fernandez, C., & Williams, T. (2024). International Perspectives on Investment Income: A Comparative Analysis of Capital Gains and Dividend Taxation Across Major Economies. Global Taxation Review.
Patel, S., & Robinson, M. (2024). Long-term Wealth Building: Tax Considerations in Buy-and-Hold versus Dividend Reinvestment Strategies. Investment Management Journal, 41(1), 112-129.

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