Exploring The Debate Between Dividends Vs Capital Gains
When are dividends better than capital gains? That’s the question I want to consider today.
Although, regular readers know I only invest in dividend-paying stocks. Having done so for many years.
But I’m not here to yell and scream about why you should be a dividend investor. Or, shouldn’t be.
I just want to objectively discuss which is better: dividends vs capital gains…
Disclosure: At no cost to you, I may get commissions for purchases made through links in this post.
Are Dividends Better Than Capital Gains?
I can only think of 2 instances when dividends are better than capital gains…
First, dividends are better than capital gains when an investor wants cash from their stocks. But does not want to sell shares to satisfy the cash requirement.
Second, a qualified dividend is better than a short-term realized capital gain. Because of the favorable tax treatment. Since qualified dividends are taxed at a lower rate. Leaving an investor with more after-tax dollars in their pocket from a qualified dividend.
Otherwise, dividends and capital gains both can be used. Equally well for building your wealth.
Next, let’s break the answer to this question down. So, we can understand exactly when and why dividends are better than capital gains.
Then, before you go. Be sure to check out our complete group of dividend investing posts.
For more reading about making money off dividends. Since we have 100+ dividend investing articles and counting!
But now, back to the topic at hand…
What Are Dividends?
First of all, dividends are distributions of economic value. They are made by a company to owners of the company’s stock.
Furthermore, distributions can come in a variety of forms. But cash dividends are the most common.
Finally, dividends vs capital gains are sourced from company profits. And distributing cash dividends to shareholders. This is just one way a company can share its financial success with its owners.
Ordinary Vs Qualified Dividends
For tax purposes, dividends are classified in one of two ways: qualified and ordinary…
Qualified dividends received preferential tax treatment. Thus, they are taxed at lower rates than ordinary income.
Making qualified dividends worth more than some other forms of income. After factoring in taxes.
To be classified as qualified, a dividend must…
First, be paid by a U.S. company. Or, a qualifying foreign company.
Second, not be listed by the Internal Revenue Service (IRS) as non-qualifying. For example, dividends from real estate investment trusts (REITs) are listed by the IRS as non-qualifying.
Finally, the required holding period has been met by the investor.
If you need to be sure about whether a stock’s dividend is qualified. I suggest consulting with a tax professional.
But my rule of thumb is this…
Buy and hold most U.S.-based corporations’ stock. Then you will usually receive a qualified dividend.
Non-Qualified (Ordinary) Dividends
On the other hand, non-qualified dividends do not receive preferential tax treatment.
They are taxed at the investor’s ordinary income tax rate. Which is typically higher than the tax rate applied to a qualified dividend.
Simply put, a non-qualified dividend is any dividend that is not considered qualified. Sometimes they are referred to as ordinary dividends.
Next, let’s contrast dividends versus capital gains…
What Are Capital Gains?
First, an investor’s capital contribution is the amount of their money put up to invest.
Then, when the market value of their investment exceeds the capital contribution.
The result is a capital gain.
The definition of capital gains is further refined in two ways…
Short Term Vs Long Term Capital Gains
First, capital gains are further defined by an investor’s holding period.
If the holding period is less than one year. The investor has a short-term capital gain.
On the other hand, by holding a stock for more than a year. A long-term capital gain results.
Why is the difference between short-term and long-term capital gains important?
Because long-term capital gains receive preferential tax treatment. They are taxed at the same tax rates as qualified dividends.
While short-term capital gains are taxed at higher ordinary income tax rates.
Here’s one more important concept about capital gains…
Realized Vs Unrealized Capital Gains
Second, a capital gain is either consider realized. Or, unrealized.
A realized capital gain results when a stock investor sells stock in his or her taxable brokerage account. And does so at a higher value than their original capital contribution.
This is important because selling a stock creates a taxable event. And the capital gain will be taxed based on whether it is a short-term capital gain. Or, a long-term capital gain.
On the other hand, an unrealized capital gain is not a taxable event. Thus an investor can hold his or her shares. And no matter how high the market value of those shares goes. No tax is due.
Sometimes unrealized gains are referred to as “paper profits”.
Because, on paper, the investor has generated profits over and above the original capital invested. But has not realized that gain by making a sale.
So, now that we know a lot about dividends and capital gains. And the tax implications of both forms of investment returns.
Let me further explain the two cases I presented at the beginning…
The 2 Cases When Dividends Are Better Than Capital Gains
A qualified dividend is better than a short-term realized capital gain.
Because the qualified dividend is given preferential tax treatment. Resulting in more after-tax dollars in an investor’s pocket.
Dividends are better than capital gains when an investor requires cash from his or her stock portfolio. But does not want to sell shares to satisfy that requirement.
So, if an investor does not mind selling his or her shares. To generate cash from their stock portfolio.
A dividend is no better than a capital gain. Essentially, they are the same. And have the same tax consequences.
Thus, a dollar is a dollar. Whether it comes from dividends or capital gains. To do with as they please. They can spend it, save it, or reinvest it.
Why should investors care? The answer is, that they shouldn’t.
So, this dispels a myth that some investors believe in. That dividends are just free money. Believe me, they are not.
To further this point…
Why Aren’t Dividends Better Than Capital Gains?
There are good reasons stocks without dividends should not be ignored.
Let’s go through these next.
Because by believing high dividends are better than capital gains. You may be falling into an investment trap.
Many Successful Investments Do Not Pay Dividends
First, there are many great companies to invest in. They do not pay dividends. But their share prices rise dramatically resulting in large capital gains.
It provides for the classic debate. Investing for dividends or growth.
Amazon is a perfect example. Since the company does not pay dividends and capital gains from the stock have been outstanding.
For example, starting from the beginning of 2016. Through the end of 2020. Amazon’s stock price increased by almost 5 times.
As a result, Amazon stock outperformed many dividend stocks during this period.
Cash Is Available From Homemade Dividends
Second, if an investor does not mind selling shares after holding for at least one year. And is selling shares for zero commission.
Cash can be harvested from a portfolio. Without the aid of dividends. To meet an investor’s ongoing cash requirements. For retirement, additional income, or, other reasons.
This is sometimes referred to as creating homemade dividends.
Finally, if you are not trading your stocks for free. You should be doing so to save money.
I use the Webull app for buying and selling stocks. It’s fast, has excellent research capabilities, and provides zero-commission stock trading.
A Dollar Is A Dollar After Taxes
Finally, whether the cash realized from an investment is received in the form of a qualified dividend. Or, through the sale of stock. Resulting in a long-term capital gain.
The cash generated has the same after-tax value.
Thus, making the money from dividends is no better than the money generated from capital gains. As long as the investor does not mind selling shares.
In the end, either is a good method to build your wealth.
Are Dividends Better Than Capital Gains?
To sum up, I can only come up with 2 situations when dividends are better than capital gains.
First, when an investor wants to harvest cash from a stock portfolio. But doesn’t want to sell shares to do so.
Second, when the dividend received is qualified for tax purposes. But the capital gain is short-term and taxed as ordinary income.
So, is it dividends or capital gains for you? Based on what we discussed it shouldn’t matter.
Therefore, every investor should decide what they prefer to pursue. Dividends, capital gains, or both.
This decision should be based on one’s investment objectives and goals.
More Reading About Dividends From Dividend Stocks
If you found this post useful. Then, check out our robust set of other dividend investing articles.
My Favorite Places To Find Great Dividend Stocks
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The first is the Simply Investing Report & Analysis Platform. An interactive database of hundreds of stocks. Plus, recommendations on the best stocks to buy now.
The second is the Motley Fool Stock Advisor. Providing expert stock analysis and recommendations delivered to your inbox every month.
Author Bio, Disclosure, & Disclaimer: Please join me (Tom) as I try to achieve my goals, find my next place to live, and make the most of my money. But understand, I am not a licensed investment adviser, financial adviser, real estate agent, or tax professional. I’m a 50-something-year-old guy, CPA, retired finance professional, and part-time business school teacher with 40+ years of DIY investing experience. I’m just here because I enjoy sharing my findings and research on important topics. However, nothing published on this site should be considered individual investment advice, financial guidance, or tax counsel. Because this website’s only purpose is general information & entertainment. As a result, neither I nor Dividends Diversify can be held liable for any losses suffered by any party because of the information published on this blog. Finally, all written content is the property of Dividends Diversify LLC. Unauthorized publication elsewhere is strictly prohibited.