Capital Gains vs. Dividend Income: An Overview

Both capital gains and dividend income are sources of profit for shareholders and create potential tax liabilities for investors. Here's a look at the differences and what they mean 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. Investors do not make capital gains until they sell investments and take profits.

Dividend income is paid out of the profits of a corporation to the stockholders. It is considered income for that tax year rather than a capital gain. However, the U.S. federal government taxes qualified dividends as capital gains instead of income.

Key Takeaways

  • Capital gains are profits that occur when an investment is sold at a higher price than the original purchase price.
  • Dividend income is paid out of the profits of a corporation to the stockholders.
  • 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 rate for dividend income differs based on whether the dividends are ordinary or qualified, with only qualified dividends obtaining the lower capital gains tax rate.
  • As a practical matter, most stock dividends in the U.S. qualify to be taxed as capital gains.

Capital Gains

A capital gain is an increase in the value of a capital asset—such as a stock 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 an investor who bought 500 shares of stock in company XYZ at $5 per share, for a capital expenditure of $2,500 (500 x $5 = $2,500). Suppose that the shares rally to $7 each, making the total value of the investment rise to $3,500 (500 x $7 = $3,500). If the investor sells the shares at market value, the ending capital is $3,500. The capital gain on this investment is then equal to the ending capital minus the initial capital, for a capital gain of $1,000 ($3,500 - $2,500 = $1,000).

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. Companies keep most profits 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 nonrecurring special dividends individually or in addition to a planned dividend.

As an example, consider company XYZ, previously mentioned. The investor who bought 500 shares of stock at $5 per share for $2,500 benefited when the stock price rose. Regardless of the movement in the price of the stock, the investor benefits if company XYX announces a special dividend of $0.10 per share. In this case, the investor has dividend income of $50 (500 x $0.10).

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 short-term or long-term holdings. Capital gains are short-term when the investor sells the asset after holding it for less than a year. In this case, short-term capital gains are taxed as ordinary income for the year.

Long-term capital gains are usually taxed at the lowest rates available outside of tax-advantaged accounts. It follows that qualifying as a long-term capital gain is highly desirable.

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. As of April 2020, federal capital gains tax rates in the U.S. ranged between 0% and 20%. For middle-income investors, the national tax rate for capital gains was 15%. Some states, such as California, also tax capital gains.

Dividends are usually paid as cash, but they may also be in the form of property or stock. Dividends can be ordinary or qualified, and all ordinary dividends are taxable as income. Qualified dividends receive the lower capital gains rate. So, qualified dividends are capital gains for tax purposes. As a practical matter, most stock dividends in the U.S. qualify to be taxed as capital gains.