People invest in capital assets for the potential cash flow and appreciation possibilities. These take the form of dividends and capital gains. While both can aid in portfolio profitability, capital gains and dividends are quite different.
Capital Gains – Focusing on the Sale
When you invest in stocks or real estate, you’re directing capital toward those assets. And when you sell those stocks or real estate, you receive a profit, or capital gain. Specifically, the IRS classifies a capital gain as “the difference between the adjusted basis in the asset and the amount you realized from the sale.”
You don’t realize those capital gains until you sell the asset and take the profit. How that profit is taxed depends on how long you owned the stock or real estate. If you held it for less than one year, your capital gains are taxed at the ordinary income tax rate. If you have that asset for more than one year before selling it, you pay taxes based on the capital gains tax rate.
Dividends – Receiving Profits
Dividends, or dividend income, is what you receive for investing in a company. A corporation pays your dividends out of earned profits. Unlike capital gains, you don’t sell stocks to generate dividends (though selling stocks would lead to capital gains). Furthermore, you’ll pay taxes on those dividends for as long as you own the stock.
And unlike capital gains, dividends can carry different tax requirements, depending on whether that dividend is qualified or non-qualified.
Non-Qualified Dividends
A non-qualified dividend, or ordinary dividend, is taxed at the ordinary income rate. In other words, your federal tax bracket on ordinary income determines what tax you’ll pay on that dividend. Non-qualified dividends include:
- Distributions from REITs or master limited partnerships
- Dividends paid on employee stock options
- Dividends that don’t qualify for a lower tax rate, as they don’t meet the IRS’ minimum holding period
Qualified Dividends
Qualified dividends are paid by most domestic corporations and certain qualified foreign companies, in which you have held the asset for a minimum time period.
Qualified dividends are taxed at a lower rate, as long as they meet specific requirements (such as length of hold). Qualified dividends are taxed at the capital gains rate; higher earners might also be impacted by the Affordable Care Act’s 3.8% net investment income tax.
Sales versus Income
Capital gains and dividends can provide monetary benefits to you as an investor. But they differ in terms of how/when your receive those funds and their tax requirements. Knowing the purpose of capital gains and dividends can help you form an effective investment strategy, while understanding the taxes you might owe on proceeds.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
