Dividends vs Capital Gains
When it comes to investing, there are two main types of earnings: dividends and capital gains. Dividends are payments made by a company to its shareholders from its profits. The payments can be in the form of cash, shares, or other assets. Capital gains are the profits made on the sale of an asset, such as a share or property.
What Is a Dividend?
A dividend is a payment of money made by a company to its shareholders from the company’s earnings. The most typical form of dividend is when a business pays out cash, but it can also include goods such as gift certificates. Companies usually pay their shareholders dividends because it can be seen as a sign of financial health and stability. For example, a company that has just reported an annual profit of $10 million might decide to declare a dividend payment of 10% or $1 million. Despite being called “dividends”, the money distributed is not technically taking away from the firm’s profits nor does it reduce shareholder equity because profits are calculated before dividends are paid.
How Does It Work?
When a company pays out a dividend, it is first important to understand how the dividends are paid. There are two types of dividend payments: cash and stock.
Cash dividends are paid out in physical money, such as U.S. dollars or British pounds.
Stock dividends are the distribution of additional shares in a company, which increases each shareholder’s balance. This can be seen as an advantage to shareholders because it does not cost anything out of pocket and there is no tax on stocks given. However, stock dividends also mean that the company’s earnings will be divided among more investors who all now own a smaller percentage of the company.
What Is a Capital Gain?
A capital gain happens when you sell an asset for a price that is higher than what you bought it for, resulting in a profit. Capital gains are not realized until you actually sell or exchange that asset. For example, if you buy a share worth £100 for £105, your capital gain is £5. If you hold on to the share and then sell it for £110, you make a profit of £10.
How Does It Work?
Capital gains are taxable in most countries around the world. The government wants to tax capital gains because it sees it as income generated from the sale of an asset, which is not a regular occurrence like salary or wages. The amount of tax you pay on your capital gains depends on your income tax bracket and the length of time you held onto the asset. Generally, the longer you hold an asset before selling it, the less tax you will have to pay.
Difference Between Dividends and Capital Gains
One key difference between dividends and capital gains is that dividends are taxed, while capital gains are not. This is because the government sees dividends as normal income, while it views profits from the sale of assets as a one-time event. Another difference is that dividends are paid out by companies to their shareholders, while capital gains are realized through the sale of an asset. Also, capital gains are ideal for those who want more control over their investments because you can decide when to sell the asset. On the other hand, dividends are set by companies rather than at the discretion of investors. When it comes to the future, dividends are more stable because companies tend to pay them out regularly. Capital gains, on the other hand, can be more volatile because the prices of assets can go up or down.
Pros and Cons of Investing in either Type
There are pros and cons to investing in either dividends or capital gains. When it comes to dividends, one pro is that they are regular and stable payments. Another pro is that they are taxed at a lower rate than capital gains. On the downside, dividends can be seen as a sign of financial instability and they can be misleading. For example, a company might pay out dividends even if it is struggling to survive. The other negative aspect of investing in dividends is having to deal with reinvestment because dividends are not paid directly into your bank account. Capital gains have the advantage of being tax-free, which can result in profit amounts being higher. However, this is balanced out by the risk of volatility — meaning that you can lose money if the price of an asset falls. Another downside to capital gains is that profits are calculated after dividends are paid.
The Future Outlook for Both Types of Investments
Dividends and capital gains each have their own future outlook based on certain factors such as market conditions and volatility, risk preference, and other individual circumstances. However, if you are looking for a regular and stable income, then dividends might be a better option. On the other hand, if you are more interested in making short-term profits, capital gains might be a better choice. Ultimately, it comes down to your preferences and the type of company you invest in.
At the end of the day, it is important to understand the key differences between dividends and capital gains so you can make an informed decision about where to invest your money. Both types of investment have their own benefits and drawbacks, so it is important to weigh up the pros and cons before making a decision. Remember to always consult with a financial advisor to get tailored advice based on your individual circumstances.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.