How do dividends and capital gains differ?

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Here we compare dividends with capital gains.
Here we compare dividends with capital gains.

There are generally two ways to build wealth through investment: dividends and / or capital gains. They both fuel growth, but in different ways, with different tax implications. Understanding dividends and capital gains is an important part of managing your investments and your tax liability.

Dividends defined

Companies sometimes offer a regular dividend payment for investors who own their shares. Many companies pay dividends every quarter. However, companies also make monthly, semi-annual, or annual dividend payments.

Each dividend represents part of the company's earnings. A dividend payment depends on the number of your own shares and the amount paid out. Suppose you own 100 shares of one company. If the dividend payout is $ 1 per share, you will receive a $ 100 dividend payout.

Not all stocks pay off. For example, growth stocks usually don't pay dividends. These companies typically invest their profits in further growth. On the other hand, the blue chip stock of an established brand can pay substantial dividends.

The overall financial profile of a company often determines the dividend distribution. Earnings, profitability and corporate debt often influence the dividend. Some investors are looking for dividend aristocrats or companies that systematically increase their dividend payout for 25 years or more in a row.

Some mutual funds not only receive dividends from stocks, but also pay dividends. These dividends represent the overall results of all the underlying companies in the fund. A real estate investment trust (REIT) must distribute 90% of the profit to shareholders as a dividend.

Capital gains defined

Here we compare dividends with capital gains.
Here we compare dividends with capital gains.

A capital gain is essentially what happens when you buy stocks at a price and sell them at a higher price. This is the profit you make with an investment.

Let's say you buy 100 shares of $ 10 each with a total investment of $ 1,000. You then sell the same 100 shares for $ 50 and put $ 5,000 in your pocket. Your capital gain is the difference between what you did and what you paid, or 5,000 – 1,000 = 4,000.

Realizing capital gains is a good thing, as it means that your investments have performed well and / or that you have the market in buying and selling properly. Buying low and selling high consistently can pay off in terms of portfolio growth. However, this approach is a little more strategic because it is up to you to shape your schedule of buying and selling stocks. With dividend stocks, you receive payments on a schedule set by the company.

Dividends against capital gains: taxation

Both dividends and capital gains are tax relevant. However, specific rules apply to each of them. Let's look at the dividends first.

Qualified against unqualified dividends

Dividends are not all the same. They are divided into qualified or unqualified categories. Dividend-paying stocks or mutual funds are most likely to pay qualified dividends. These dividends are subject to the long-term capital gains tax rate.

The tax rate on capital gains that you pay for qualifying dividends depends on your registration status and household income. For 2020, taxpayers pay 0%, 15%, or 20% for long-term capital gains tax. Some high-income taxpayers will also pay a 3.8% net income tax on dividend income.

Unqualified or ordinary dividends come from sources other than shares. For example, savings accounts, money market accounts, certificates of deposit and REITs pay unqualified dividends. The IRS will tax these dividends at your marginal tax rate. In other words, they fall into the highest tax bracket that is available based on income.

Qualified dividends generally offer investors an inexpensive tax option. If you are an income earner, you are likely to owe less tax even if the maximum withholding tax rate is reached than if you were taxed at your marginal tax rate.

Short-term vs. long-term capital gains

When you make capital gains from selling a stock or other investment, its taxes depend on how long you have held the investment. The short-term investment income tax rate applies to investments held for less than a year. This tax rate corresponds to your normal income tax rate. In other words, short-term capital gains are subject to the same taxes as money earned from your work or self-employment.

The tax rate for long-term capital gains is cheaper and starts when you sell an investment that you own for a year or more. These are the same rates as for qualified dividends: 0%, 15% and 20%. Again, the rate you pay depends on your registration status and household income. By checking the numbers in a capital income tax calculator, you can estimate how much tax you owe before selling a stock.

Management of tax liability on investment income

Here we compare dividends with capital gains.
Here we compare dividends with capital gains.

When you get dividends or capital gains, it depends on the strategy and knowing what you own. For example, you could assume that reinvesting your dividends in additional shares of the same share will help you avoid paying income tax on the distributions because you will not receive cash. However, the IRS believes that annual income is taxable, which means that it must be shown in your tax return.

With capital gains, you can use a tactic that can potentially minimize your tax debt. It is known as the tax loss earner. It contains Selling stocks that have lost money throughout the year to offset the gains made by another stock in your portfolio. The key avoids the laundry sales rule.

This IRS rule states that you cannot sell shares of a share and buy shares of a substantially similar share within 30 days before or after the sale date. If the IRS determines that you have done so, your ability to offset capital gains by harvesting losses will be effectively canceled. This rule is designed to prevent investors from playing the system and avoiding their tax liability for capital gains.

The bottom line

There are subtle differences between dividends and capital gains, especially in terms of taxes. The good news is that you don't have to choose between one for an investment. It is possible to include both in your portfolio. However, whether you should do this largely depends on your goals. The most important thing to keep in mind is what tax growth investment growth could mean for you.

investment Tips

  • Talk to your financial advisor about large sales of stocks. You can point out the tax effects of possible capital gains. Your advisor can help you develop a strategy to minimize tax liability as much as possible. Finding the right financial advisor to meet your needs doesn't have to be difficult. SmartAsset's free tool will take you to nearby financial advisors within 5 minutes. When you're ready to get in touch with local advisors who can help you achieve your financial goals, get started now.

  • If you are considering adding dividend stocks to your portfolio, take the time to research the stock carefully. In particular, you shouldn't fall for a high dividend yield. This alone may not give an accurate picture of the stock potential. Instead, look at the fundamentals of the company and determine how dividend payments change over time. This could indicate a company's financial stability. It can also illustrate the long-term dividend potential.

Photo credits: © iStock.com / William_Potter, © iStock.com / blackCAT, © iStock.com / Malerapaso

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