There are generally two paths to building wealth through investments: dividends and capital gains. They can both fuel growth but in different ways with different tax implications. Understanding dividends vs. capital gains is an important part of managing your investments as well as your tax liability.
Consider working with a financial advisor to weigh the pluses and minuses of focusing on dividends or capital appreciation.
Dividends Defined
Companies sometimes offer a periodic dividend payment for investors who own their shares. Many companies pay dividends quarterly. However, companies also make monthly, semi-annual or annual dividend payments.
Each dividend represents a portion of the company’s earnings. A dividend payment depends on the number of shares you own and the dividend payout amount. For example, say you own 100 shares of a company’s stock. If the dividend payout is $1 per share, then you’d receive a $100 dividend payment.
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.
Acompany’s overall financial profile often determines its dividend payout. Earnings, profitability and company debt often influence dividends. Some investors seek out Dividend Aristocrats, or companies that systematically increase their dividend payout for 25 consecutive years or more.
Aside from receiving dividends 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.
Capital Gains Defined
A capital gain is essentially what happens when you purchase shares of stock at one price and sell them at a higher price. This is the profit you make on an investment.
Say you purchase 100 shares of stock at $10 each, for a total investment of $1,000. You then sell those same 100 shares for $50, putting $5,000 in your pocket. Your capital gain represents the difference between what you made and what you paid, or $5,000 – $1,000 = $4,000.
Realizing capital gains is a good thing because it means your investments performed well or you timed the market correctly in buying and selling. If you’re consistently buying low and selling high, that can pay off in terms of portfolio growth. This approach is a little more strategic, however, since it’s up to you to shape your timeline for buying and selling shares of stock. With dividend stocks, you receive payments on a schedule set by the company.
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 alike; they divide 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.
The 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 the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors who serve your area. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- If you’re considering including dividend stocks in your portfolio, take time to research the stock carefully. Specifically, don’t fall 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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