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Difference Between Capital Gains & Dividends

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Not all returns are created equal, especially in the eyes of the government. While you may think a 10% return is the same regardless of whether it is categorized under capital gains or dividends, the “powers that be” would beg to differ. In fact, the US tax code treats the two sources of return very differently. What’s the difference?

When we look at capital gains & dividends, we are specifically talking about after-tax or non-qualified accounts. You do not pay capital gains tax or dividends tax inside of an IRA/401(k)/Qualified account. 

As always, please consult a CPA or qualified tax advisor if you have any questions related to your specific tax circumstances.

Capital Gains & Dividends - Infographic


Long-term capital gains & qualified dividends are taxed from 0-20%, and short-term capital gains & ordinary dividends are taxed at 10-37%, depending on your income bracket. This isn’t the only difference between the two; each source of return has its own advantages and disadvantages, and there is no one-size-fits-all solution.

Capital Gains

Capital Gains-1


The return often referred to as “capital gains” is simply the change in the price of an asset over time. For example, if you bought stock A for $10 per share and you sold it at $12 per share, the capital gains on that particular investment would be $2, or 20%. You will then be taxed on the $2 gain.
This differs from dividends in one key aspect: you decide when you want to recognize the gain.

Do you want to sell the asset at $12 or hold onto it in hopes it will increase even further?

If you decide to hold on to the asset, your capital gains could rise to $15, $20, or more. This matters for taxes because you are taxed based on the gains. So, if you hold onto the asset hoping the return will increase, the taxable portion of the investment will increase as well.

The most important part in the phrase in the previous sentence: you decide.

You decide when you want to recognize the return on an asset. If you don’t want to pay taxes on it this year, and you’d rather wait until next year to recognize the gains, then you don’t have to sell the asset. Short-term versus long-term capital gains are also taxed differently, with a lower tax rate on long-term capital gains to incentivize investing over trading.

The tax treatment of capital gains can help lower your taxable income in a given year. If you have lost money on an investment and are considering changing your investment strategy, you can sell the asset for a loss and receive a tax benefit (lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on line 21 of Schedule D (Form1040)) from the losses incurred on the asset, but it is important to note that this is never the primary reason to sell.

Note: You aren’t able to sell a losing security in order to claim a loss then turn around and purchase the same security within 30 days. This is known as the “wash-sale rule” or 30 day rule, and the IRS uses it to keep people from churning investments to capture losses to lower their taxable income. However, if you have already been thinking about selling an investment for other reasons, the losses can be wisely used to lower your taxable income.

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Dividends

Dividends


Dividends (cash payments made from corporations to shareholders) can be an important source of return, but are treated differently than capital gains for tax purposes. As mentioned before, ordinary dividends can be taxed as high as 37%, and qualified dividends can be taxes as high as 20%.

Since dividends are the remaining profits of a corporation, the corporation has already paid taxes on the dividends when they are distributed to shareholders. This is what is commonly referred to as double taxation: the dividends are taxed at both the corporate and individual level. All else being equal, this makes the dividend a less advantageous source of return; however, many investors believe that a company’s ability to pay a consistent dividend speaks to the strength of the overall company.

You receive the dividends whenever they are paid by the corporation, and they are taxed in that year, so you have no control over when to recognize the returns for tax purposes. But despite any shortcomings, dividends are a significant source of return for many investors.

Those who have held the same securities for a very long period of time (20+ years) will have very large capital gains taxes to pay when the gains are finally recognized. If those companies pay dividends, some investors may never need to recognize the gains on the assets and may live a very comfortable life on the dividends alone, alleviating the headache of having to pay a large tax bill once the gains are recognized.

 

 

The Takeaway


Both capital gains and dividends have unique treatment in the US tax code, and knowing how to incorporate these differences into your financial plan can help save you money to put toward better use in the long run.

If you have any questions, or you’d like further explanation, we are here to help. Together, we can find the appropriate portfolio and tax strategy for you.

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