Capital Gains vs. Dividend Income: An Overview

Both capital gains and other investment income, such as dividend income, are a source of profit and hold potential tax consequences. Here's a look at the differences between the two types of income and what each one means in terms of investments and taxes paid.

Capital is the initial sum invested. So, a capital gain is a profit that occurs when an investment is sold for a higher price than the original purchase price. An investor does not have a capital gain until an investment is sold for a profit.

Dividends are assets paid out of the profits of a corporation to the stockholders. The dividends an investor receives are not considered capital gains, but rather income for that tax year.

Capital Gains

A capital gain is an increase in the value of a capital asset—either an investment or real estate—that gives it a higher value than the purchase price. An investor does not have a capital gain until an investment is sold for a profit. By contrast, a capital loss occurs when there is a drop in the capital asset value versus an asset's purchase price. An investor does not have a capital loss until selling the asset at a discount.

As an example, consider that an investor has bought 500 shares of stock in company XYZ at $5 per share, for a capital expenditure of $2,500 (500 x $5 = $2,500). Good news is announced and the shares rally to $10 each, making the total investment now $5,000 (500 x $10 = $5,000). If the investor sells the shares at market value, the total income is $5,000. The capital gain on this investment is then equal to the total income minus the initial capital ($5,000 - $2,500 = $2,500).

Dividend Income

A dividend is a reward given to shareholders who have invested in a company's equity, usually originating from the company's net profits. Most profits are kept within the company as retained earnings, representing money to be used for ongoing and future business activities. However, the rest is often given out to shareholders as a dividend. A company's board of directors can pay out dividends at a scheduled frequency, such as monthly, quarterly, semiannually, or annually. Alternatively, companies can issue non-recurring special dividends individually or in addition to a scheduled dividend.

As an example, consider company XYZ, previously mentioned. The investor who bought 500 shares of stock at $5 per share for $2500 benefits when the stock price rises. Regardless of the movement in the price of the stock, the investor benefits when company XYX announces a special dividend of $2 per share, and they net $1,000.

Special Considerations

How capital gains and dividends are taxed differs. Distinctions for capital gains are made based on whether the asset was held for a short or long period. Dividends are classified as either ordinary or qualified and taxed accordingly.

Capital gains are taxed differently based on whether they are seen as short-term or long-term holdings. Capital gains are considered short-term if the asset that was sold after being held for less than a year. In this case, short-term capital gains are taxed as ordinary income for the year.

Assets held for more than a year before being sold are considered long-term capital gains upon sale. Tax is calculated only on the net capital gains for the year. Net capital gains are determined by subtracting capital losses from capital gains for the year. For most investors, the tax rate for capital gains will be less than 15%.

Dividends are usually paid as cash, but they may also be in the form of property or stock. Dividends can be ordinary or qualified. All ordinary dividends are taxable and must be declared as income. Qualified dividends are taxed at a lower capital gains rate.

When a corporation returns capital to a shareholder, it is not considered a dividend and reduces the shareholder's stock in the company. When a stock basis is reduced to zero through the return of capital, any non-dividend distribution is considered capital gains and will be taxed accordingly. Further, an investor receiving large sums in dividends needs to pay estimated taxes to avoid a penalty.

Key Takeaways

  • Capital gains are profits that occur when an investment is sold at a higher price than the original purchase price.
  • Dividends are assets that are paid out of the profits of a corporation to the stockholders. They are considered income for the year, not capital gains.
  • The tax rates differ for capital gains based on whether the asset was held for the short term or long term before being sold.
  • The tax rates differ for dividends, based on whether they are ordinary or qualified.