How are capital gains and dividends taxed differently?

By Daniel Kurt AAA
A:

The U.S. tax code gives similar treatment to dividends and capital gains, although this will change slightly in 2013.

Currently, ordinary dividends and short-term capital gains those on assets held less than a year are subject to one's income tax rate. However, "qualified dividends" and long-term capital gains benefit from a lower rate. Qualified dividends are those paid by domestic or qualifying foreign companies that have been held for at least 61 days out of the 121-day period beginning 60 days prior to the ex-dividend date.

In the case of qualified dividends and long-term capital gains, individuals in the 25% or higher tax bracket currently pay a 15% tax, whereas those in lower brackets are exempt from any tax. Beginning in 2013, the long-term capital gains rate will jump to 10% for lower income earners and 20% for investors in the higher brackets.

Meanwhile, the preferential treatment given to qualified dividends is set to disappear completely. As of 2013, individuals will have to pay their income tax rate on all dividend income they receive.

In Canada, tax treatment is a little simpler because there's no parsing of capital gains and dividends into different categories. In the case of capital gains, residents pay their marginal tax rate, but only on half the amount. Under certain conditions, selling one's primary residence is exempt from taxation altogether.

Dividends also get preferential treatment in Canada, although it may not seem that way on the surface. Investors have to pay their marginal income tax rate, and 125% of the dividends are taxable. However, national and provincial credits (the federal dividend tax credit alone is 13.33% of the taxable amount) help offset one's liability. Consequently, the actual tax can end up being significantly lower than one's income tax rate.

Here's an example. Let's assume you're in the 25% tax bracket and received $10,000 in dividends for the year. Your earnings are "grossed up" to $12,500, so your initial tax liability is $3,125. But if you assume a 5% provincial tax credit, that amount is reduced by $625 ($12,500 x 0.05 = $625) and by an additional $ ($12,500 x 0.1333 = $1,666.25) at the federal level. In the end, your tax liability is only $833.75, or 8.3% of your actual dividend income.

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