These two terms are occasionally used interchangeably, but they refer to different processes that can produce a taxable result in your investment accounts. They are terms that you hear frequently on the news, business channels, and publications, so I thought that it might help to break down the terminology a bit.
I should start by clarifying that dividends and capital gains are deferred in qualified or tax-sheltered accounts such as IRAs (Individual Retirement Accounts) until such time as you make a withdrawal from that account. This is in comparison to a non-qualified, or non-tax-sheltered type of account, that could be titled as an Individual investment account, a Joint account, a Trust, etc.
So back to dividends and capital gains:
A dividend is a cash payment made by a company to its shareholders out of the company’s profits, with payments usually made quarterly. Example: in May of 2019, Starbucks paid a cash dividend of $0.36 per share, so if you owned 100 shares of Starbucks, your investment account would have received a payment of $36.
A capital gain occurs when you sell a stock or fund, including ETF’s (Exchange Traded Funds) and Mutual Funds, and you receive more than what you paid for it: buy for $50, sell it for $75, so you make money on the sale. You can also incur capital losses, which is when you sell something for less than you paid for it. Sometimes you may do this intentionally, as losses and gains can offset one another, in terms of taxation.
What are the tax implications of dividends and capital gains?
Remember that in those tax-sheltered accounts such as IRA’s, there is no immediate tax consequence, unless and until you withdraw funds from your IRA, payable to yourself. In the case of the other types of accounts, dividends and capital gains are taxable. How much? It depends- which is almost always the answer when it comes to taxes! However, there are some basic rules to help give you an idea of the taxes on them:
- Dividends– those cash payments from the company to shareholders- can be taxed at your ordinary income tax rate- so whatever the individual tax rate is that you pay each year, which can vary from 10-37%.
- In terms of capital gains, the first determination is how long you had the investment. If you had it less than a year, you will be taxed at whatever your ordinary income tax rate is, which again is anywhere from 10% to 37%. Conversely, if you held it for at least 12 months and one day your tax on capital gains could be 0-15% for most individuals, or up to 20% for incomes above about $435,000 for single taxpayers.
- Side Notes:
- Because of the taxable implications, it is generally not a good idea to do frequent trading in non-tax-sheltered accounts, which have growing tax consequences with the increased frequency. On top of the capital gains and/or dividends that result in the higher tax rates due to owning them for shorter periods of time, you are also incurring trading costs with each trade. You really need to know what you are doing and have time to devote to it if you want to do a lot of trading or “day trading”.
- To avoid potential issues with calculating the correct tax rates as a result of your transactions, be they capital gains, losses or dividends, we strongly recommend that you hire a tax preparation professional, rather than trying to do it all yourself.
What do I Do with my Dividends or Capital Gains?
In general, unless you want to use them as a source of supplemental income, we recommend that you re-invest these profits- either into more shares of the same stock that paid the dividend, or perhaps another investment option that is a better buy, i.e., is “on sale”, in order to increase the long term growth of your investment portfolio. Likewise, with the capital gains on the sale of assets- unless you were selling because you needed cash, reinvest those funds into something else.
While you may incur taxes if your selected investments are profitable, which is kind of the goal, if you take the really long view, there is a tremendous benefit that you will not receive, but your beneficiaries will: upon your death, the beneficiary of a non-tax-sheltered account – and you definitely should name beneficiaries for each of these accounts- will receive what is called a “Step up in Basis”- which simply means that all of the gains that have occurred in the account from the date that you started it up until the date of your death will pass Tax Free to your heirs. The value of the account on the date of your death becomes the new “basis” or principal, if you will, which can result in a tremendous benefit for your loved ones. Just another little something to think about!