There are two basic ways to earn a profit from owning shares in a company. If the company pays a dividend, you receive regular income, usually on an annual or quarterly basis, while you remain a shareholder. If the market value of the investment rises, you can sell the shares; you'll no longer be a shareholder if you sell them all, and the income you receive from the sale is a capital gain. The length of time you hold the investment determines whether you have a long- or short-term capital gain. Always consider the tax implications of dividends and capital gains when planning strategy for your investments; long-term capital gains are taxed at special rates, while short-term capital gains are taxed as ordinary income.
Dividends are paid out to current shareholders (generally only to those holding preferred stock), while capital gains is earned when a shareholder sells their shares for profit.
Defining a Dividend
A company that wants to return a portion of its earnings to shareholders pays a dividend. A dividend payout supports the price of the stock by offering a stream of income, in most cases higher than the interest earned from a savings account or money-market account. The company declares the dividend ahead of time and sets the "record date" -- the date on which you must own the stock to earn the dividend. On the payment date, the dividend money arrives in your brokerage account in the form of cash. You may reinvest dividends by using them to buy more shares of the stock.
Only current shareholders of a company receive dividends, so if you hold onto your stock, you might receive them. If you sell your stock, however, the income is not a dividend, but is instead a capital gain.
Exploring Capital Gains
When you sell a stock, you realize a capital gain if you've received more money than you paid to buy the stock. Unless they are held in certain retirement or tax-sheltered accounts, capital gains are taxable. The IRS allows you to calculate any brokerage commissions or fees in the gain calculation, subtracting them from the proceeds of the sale and adding them to the original cost. If you hold an investment for more than a year, you realize a long-term capital gain (or loss) when you sell. Hold it less than a year, and your loss or gain is short-term.
Short-term capital gains are taxed like ordinary income, while long-term capital gains are taxed at capital gains rates. Short-term gains are added to all your other ordinary income to determine your tax bracket, and your long-term gains will be taxed according to your top tax bracket.
Assessing Tax Calculations
You must declare dividends as well as capital gains to the IRS on your annual return. The company paying the dividend sends you a 1099-DIV each year to notify you of the amount. You declare dividends as part of your annual income on Line 9a or 9b of Form 1040. The capital gains transactions are listed on Schedule D of Form 1040; you enter the dates that you bought and sold the shares as well as the share prices. There are separate sections for long-term and short-term gains. The IRS taxes long-term gains and dividends at the same rate; short-term gains incur a higher rate of tax.
Dividends vs. Gains
Your investing style determines whether you aim for dividends or capital gains from your shares. Dividend-paying stocks offer a guarantee of a minimum yearly income, which in a low-interest-rate environment allows them to compare well to savings accounts, money-market accounts or bonds.
If aiming for capital gains, an investor would disregard the dividend payments (if any), forgo the security of regular income and ride out the swings in share price. More aggressive investors favor long-term capital gains over dividends, and those with a time horizon of at least a year benefit from lower tax rates on long-term vs. short-term gains.
Founder/president of the innovative reference publisher The Archive LLC, Tom Streissguth has been a self-employed business owner, independent bookseller and freelance author in the school/library market. Holding a bachelor's degree from Yale, Streissguth has published more than 100 works of history, biography, current affairs and geography for young readers.