Difference Between Dividends and Capital Gains

Edited by Diffzy | Updated on: September 22, 2022

       

Difference Between Dividends and Capital Gains Difference Between Dividends and Capital Gains

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Introduction

When does one stop? For good? The light at the end of a tunnel or that sunset horizon, might seem like the end of a journey but truly, how do you know for sure? Upon reaching that endpoint there is, most likely, going to be another light and tunnel or horizon. The need to get to the very last bit of your adventure will keep you soldiering on. The quest never stops. Curiosity is what drives you. It is not only the thirst for adventure, even the wish for knowledge or the yearning to be the most powerful or popular or simply want to be rich.

As soon as one goal is achieved, we set our next target and work hard to fulfil that goal. We always want more. We often want as much as we can get. From all sources possible. Even my pets could attest to that. While we are having dinner, the trail of their drools lines from one person to the next. And this happens immediately after they are fed. They give you the saddest look till you pity them and share your slice of bread or they terrorize you with bark and get you to surrender. Either way, they get what they want from multiple sources proving that having a meal just once is never enough. It is the same with humans.

Dividends vs. Capital Gains

Dividends and capital gains are additional forms of income that one can gain from the market. While having a safe and steady job ensures solid pay, prudent investments in the market add to the income. Dividends and capital gains are ways that investors can gain profits from their investments. Dividends are interest payments issued by the company that the person has stock in, while capital gains are the profits earned when the investor sells the stock or capital assets for a higher price than the original. Let us see how else they differ from each other.

Difference Between Dividends and Capital Gains in a Tabular Form

Table: Dividends vs. Capital Gains
Parameters of Comparison Dividends Capital Gains
Definition
Dividends are a percentage of the profits given by a company to the investors.
Capital gains are profits gained after the selling of an investment.
Periodicity
A dividend is paid periodically. It is dependent on the company’s policies.
A capital gain is only realized on liquidation.
Depend
A dividend is dependent on the decisions made by the senior management.
A capital gain is dependent on the market value of the investment.
Taxes
With dividends, lower taxes are charged.
With capital gains, the tax liability is high but it is dependent on the term of the investment (short-term or long-term).
Profits
Dividends form a part of the profits that are distributed by the company to the shareholders.
The profits from capital gains increase in value with long-term assets.
Investment required
A relatively small investment is required to purchase a stock of a company.
To obtain higher capital gains, a larger investment is required.
Profits gained at
Dividends are distributed periodically.
A capital gain occurs only once in a lifetime of the investment.
Control
The investor has no control over the dividend.
The investor has control of the capital gain.

What is a Dividend?

A dividend is an income received from the profits achieved by the company. This amount is paid periodically – yearly, quarterly or monthly. The objective of a dividend is to attract investors but certain companies state that the investor must own a stock for a limited period to be eligible for a dividend.

The amount of the dividend is determined by the senior management of the company. It is equally divided among the shareholders. A decision about the dividend is independent of the performance of the company. If a company is doing poorly financially, it can decide to not offer dividends. Conversely, if a company is performing excellently, even then, it could withhold the dividends.

The steps of how a dividend is obtained are as follows:

  1. A company earns profits.
  2. The senior management decides to share the profits equally amongst the shareholders.
  3. The decision of the management is approved by the board of directors.
  4. The rate of dividends is announced.
  5. The dividends are paid to the investors.

An example of the working of dividend is as follows, say, a person invests 1000 rupees in 100 shares of a company A, the price of each share is 10 rupees. After a year, if the company gets a profit of 100 lacs and decides to offer a dividend of 2 rupees per share, the investor receives 200 rupees for their shares.

Dividends can be of different types.

Some of them are as follows:

  1. Cash: it is the commonest way of paying dividends. The cash is transferred directly to the bank or given through a check to the investors.
  2. Stocks: new stocks for the dividends can also be issued to the investors instead of cash. These stocks are given on a pro-rata basis.
  3. Assets: a company can also offer assets in place of cash or stocks. They can give the investors real estate or other physical assets or material economic resources.

There are other methods to pay dividends as well but those methods due not guarantee immediate payment. Dividends are also not decided automatically. A company takes into consideration multiple factors like their earnings, debts and profitability. It is advised to the investor to look for companies that have been consistent with their dividend payouts for more than twenty years. Since dividends do not constitute a particularly high income, they do not have high taxes. The tax liability for dividends is relatively low compared to capital gains. Thus, in the long run, dividends provide a favourable tax option.

What are Capital Gains?

A capital gain is a profit earned from the capital assets. When there is an increase in the asset or an investment owned by the investor, the investor can sell the asset and gain a profit. Thus, the investor sells their stocks or shares when their market value rises so that they can benefit from the profit. Capital gains include the whole capital, not just the stocks or investments.

Capital gains are tax liable depending on the type of investment – whether it is a short-term or a long-term investment. The rules for the tax vary accordingly. The short-term ones are usually taxed the same as the dividends while the long-term ones are taxed differently. If the investment is short-term or when the stock is owned for less than a year, the tax rate is almost the same as that on the regular income. In the case of long-term investments lasting longer than a year, the tax rates are applicable once the stock or asset is sold for a higher price. Most investors favour the latter option.

It has been found that the tax treatment of capital gains can reduce the taxable income in a year. Say a person faced losses with an investment, they can sell the investment at a lower price and reap the tax benefits from the loss incurred. This, however, is never the primary reason to sell an asset.

An example to see how a capital gain works is as follows:

Say an investor has invested 1000 rupees in stocks of a company A and purchased 100 stocks, the price of each being 10 rupees. After a year, with the company trading at 20 rupees, the investor decides to sell the stocks. They will then earn 2000 rupees. Since the initial investment for purchase was 1000 rupees, the capital gain is calculated as follows:

Capital gain = Sale price – Purchase price = 2000 – 1000 = 1000 rupees.

Thus, the capital gain earned by the investor is 1000 rupees. Over time, it has been found that the value of the investment increases but this rise in value is solely dependent on the market.

To gain a capital asset that could fetch a capital gain, a large investment is required which also includes a higher risk when compared to dividends. Also, a capital gain can occur only once in the lifetime of the investment since it occurs only after the sale of the investment. Having capital gains indicates that the investments are performing well and the individual understands the market rules clearly. 

Capital gains can be of two types.

They are as follows:

  1. Realized gain: is the gain that is obtained once the stock or the investment is sold at a higher price in the market to a third party. It can either be long-term or short-term.
  2. Unrealized gain: when the investment or stock is not sold despite the rise in its market value, it is called an unrealized gain.

Difference Between Dividends and Capital Gains in Points

Following are the main differences between dividends and capital gains:

  1. A dividend is a percentage of the profits gained by the company and distributed amongst the shareholders. A capital gain is the profit gained after selling an investment or asset.
  2. A dividend is given by the company periodically, while a capital gain can be obtained only after liquidation.
  3. A dividend is dependent on the decisions made by the senior management, whereas capital gains are thoroughly dependent on the market value of the investment.
  4. Lower taxes are charged with a dividend, but with a capital gain, there is a tax liability. The taxes are dependent on the investment term.
  5. The company profits that form the dividends are distributed amongst the shareholders, while the profits from capital gains increase in value over time.
  6. To be eligible for dividends, one must have stock in the company. The investment for purchasing a stock is relatively small. To obtain higher capital gains though, one ought to make larger investments.
  7. The profits are gained periodically with dividends, while the profits are gained only once in the lifetime of the investment.
  8. The investors have no control over the dividends, whereas they control capital gains.

Conclusion

Dividends and capital gains are both methods of increasing one’s income. They are both ways to build wealth via investments. Dividends are a portion of profits that the company shares with the shareholders or investors. This amount, however, is decided upon by the senior management after taking the company’s overall debts, profits and earnings into consideration. The investor, as such, has no control over the dividends. The investment to obtain dividends is relatively since all one has to do is purchase stocks in a company. As the purchase value is lower, the income is also lower, and thus, the tax liability is also lower.

This is not the case with capital gains. To ensure higher capital gains, the investment for the asset is higher. Therefore, the tax liability is also higher. Although, the taxes applicable are different for short-term investments and long-term investments. A capital gain essentially is the profit gained by the investor when they sell their purchased asset for a higher price in the market. It is the difference between the sale price and the purchase price. Capital gains are an indication that the company is doing well and that the investor has a sound knowledge of the market. Since the investor is the only one who gains from the profit, they have complete control over the selling of the asset. However, the value of the profit is dependent on the market. The market is very fickle. Deciding whether to invest in dividends, capital gains or both can be especially hard. One should always do proper research and analysis before indulging in such ventures. It is hard to stop once you start - the quest for a higher income. It is not wrong in the least but it is important to be prudent. Financial risks are not to be taken lightly. A poor investment could land you on the road while a good one could put you on a gilded one leading you to your castle. All of it depends on the market and the market is, like afore-mentioned, very fickle. Staying well-informed and vigil is the only way you can make the best of the market.

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"Difference Between Dividends and Capital Gains." Diffzy.com, 2022. Sun. 25 Sep. 2022. <https://www.diffzy.com/article/difference-between-dividends-and-capital-gains-283>.



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