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Almost every type of income comes with a tax consequence. Capital gains and dividends are both income but they are treated differently when it comes to taxes.
Understanding the difference between capital gains and dividend income can have an impact on portfolios and tax planning. That includes the difference in how these two incomes are taxed, says Investopedia in the article, “Capital Gains vs. Dividend Income: What's the Difference?”
Capital is the initial sum invested. A capital gain is a profit you get when an investment is sold for a higher price than the original purchase price. An investor doesn’t realize a capital gain until an investment is sold for a profit.
On the other hand, dividends are assets paid out of the profits of a corporation to the stockholders. The dividends an investor receives aren’t capital gains. This is treated as income for that tax year.
A capital gain is the increase in the value of a capital asset—either an investment or real estate—that gives it a higher value than the purchase price. A capital loss happens, when there’s a decrease in the capital asset value as compared to the asset's purchase price. There is no capital loss until the asset is sold at a discount.
A dividend is a “reward” or “bonus” that’s given to shareholders who’ve invested in a company's equity. It is usually 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 disbursed to shareholders as a dividend.
Taxes. Capital gains and dividends are taxed differently. Dividends are going to be either ordinary or qualified and taxed accordingly. However, capital gains are taxed, based on whether they are seen as short-term or long-term holdings. A capital gains is deemed short-term, if the asset that was sold after being held for less than a year.
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. The tax is on the net capital gains for the year. Net capital gains are calculated, by subtracting capital losses from capital gains for the year. For many, the tax rate for capital gains will be less than 15%.
Dividends are usually paid as cash. However, they can also be in the form of property or stock. Dividends can be ordinary or qualified. Ordinary dividends are taxable and must be declared as income, but qualified dividends are taxed at a lower capital gains rate.
When capital is returned to a shareholder from a corporation, it is not a dividend. The returned capital reduces the shareholder’s stock holdings in the company. At the point that the stock basis is reduced to zero, any distributions (non-dividends) are considered capital gains and are taxed as capital gains.
Any investor who receives large amounts of dividends needs to pay estimated taxes to avoid penalties.
Reference: Investopedia (April 11, 2019) “Capital Gains vs. Dividend Income: What's the Difference?”