Dividends are income earned by investing in stocks, mutual funds or exchange-traded funds, and they are included in your tax return on Schedule B, Form 1040. Capital gains are the amount an asset increases in value between when it is purchased and when it is sold. 

The U.S. tax code gives similar treatment to dividends and short-term capital gains, and qualified dividends and long-term capital gains, respectively.

Key Takeaways

  • Investors that earn dividends or capital gains are subject to pay taxes on those gains.
  • Short-term capital gains and ordinary dividends are treated the same as income, and taxed at the current income tax bracket level.
  • Long-term capital gains and qualified dividends have favorable tax treatment that is lower than ordinary income tax rates.
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How Are Capital Gains And Dividends Taxed Differently?

Taxing Capital Gains

Capital gains tax rates tend to be more favorable than income tax rates, and depend on how long the seller owned or held the asset. Short-term capital gains for assets held for less than a year are still taxed at ordinary income rates. However, if you held an asset for more than a year then more preferential long-term capital gains apply. These rates are 0%,15%, or 20%—depending upon on your income level.

For the 2020 tax year, you pay 0% on long-term capital gains if you have total income of $40,000 or less; 15% if you have income of $441,450 or less; and 20% if your income is greater than $441,450.

Note that capital losses can be used to offset capital gains in a given tax year, lowering the effective taxes due - although only short-term losses can offset short-term gains, and only long-term losses can offset long-term gains.

Taxing Ordinary Dividends

Ordinary dividends are treated the same as 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.

Taxing Qualified Dividends

In the case of qualified dividends, these are taxed the same as long-term capital gains, as of 2020, individuals in the 10% to 15% tax bracket are still exempt from any tax. Investors who fall in the middle brackets—25%, 28%, 33%, or 35%—pay 15% at most in capital gains. The highest earners, in the 39.6% bracket pay 20% in capital gains (plus 3.8% net investment income tax, per the Patient Protection and Affordable Care Act - see the table below).

So, although dividends and capital gains are different types of investment income, they receive similar treatment at tax time.

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