Dividends vs. Capital Gains: Which Is a Better Return?
Unpack the distinct nature of dividends and capital gains, understanding their unique tax treatments to optimize your investment strategy.
Investing often involves seeking returns on capital, which can materialize in various forms. Understanding the different ways investments generate income is fundamental for anyone looking to grow their wealth. Two primary methods through which investors typically earn returns are through dividends and capital gains. These distinct forms of investment income each possess unique characteristics regarding how they are generated and, significantly, how they are treated for tax purposes.
Understanding Dividend Income
Dividends represent a portion of a company’s earnings that is distributed to its shareholders. Companies typically pay dividends as a reward to investors for holding their stock, reflecting the company’s profitability and financial stability. These distributions can occur regularly, such as quarterly or annually, or sometimes as special, one-time payments.
The most common form of dividend payment is cash, directly deposited into an investor’s brokerage account. Companies can also issue dividends in the form of additional shares of stock, which increases the number of shares an investor owns without requiring a new purchase.
Dividends are categorized as either qualified or non-qualified (ordinary) for tax purposes. Qualified dividends generally originate from shares of stock in U.S. corporations or certain qualifying foreign corporations. To be considered qualified, the stock must be held for a specific minimum period.
Non-qualified, or ordinary, dividends do not meet the criteria for qualified treatment and are taxed at an investor’s ordinary income tax rates. Common sources of non-qualified dividends include those from money market accounts, real estate investment trusts (REITs), employee stock options, and master limited partnerships (MLPs). Dividends from tax-exempt organizations or those paid on deposits with mutual savings banks are also non-qualified.
Understanding Capital Gains
Capital gains arise when an investor sells an asset for a price higher than its original purchase price, known as its cost basis. This type of return is realized only when the asset is sold or exchanged, meaning an investor does not incur a capital gain simply because an asset’s market value increases. For example, if shares of stock are bought at $50 and later sold at $75, the $25 difference per share represents a capital gain.
Assets that can generate capital gains include stocks, bonds, real estate, mutual funds, and even collectibles. The gain is calculated as the difference between the selling price and the adjusted cost basis, which includes the original purchase price plus any commissions or fees paid when acquiring the asset. Conversely, if an asset is sold for less than its cost basis, it results in a capital loss.
Capital gains are distinguished by the length of time an asset is held before it is sold. Short-term capital gains occur when an asset is held for one year or less from the date of purchase to the date of sale. Long-term capital gains result from selling an asset that has been held for more than one year.
Taxation of Dividends
The tax treatment of dividends depends on whether they are classified as qualified or non-qualified. Qualified dividends are taxed at preferential rates, which are the same rates applied to long-term capital gains. These rates are 0%, 15%, or 20%, depending on the taxpayer’s taxable income level. For instance, in the 2025 tax year, individuals with taxable income up to $49,200 (single filers) or $98,400 (married filing jointly) often pay a 0% tax rate on their qualified dividends.
As taxable income increases beyond these thresholds, the qualified dividend tax rate rises to 15%. For the highest income earners, specifically those with taxable income exceeding $549,900 (single filers) or $659,350 (married filing jointly) in 2025, the qualified dividend tax rate is 20%.
Non-qualified dividends, in contrast, are taxed at an investor’s ordinary income tax rates. These rates range from 10% to 37% across various income brackets for the 2025 tax year.
Higher-income taxpayers may also be subject to the Net Investment Income Tax (NIIT) on certain dividend income. The NIIT is a 3.8% surtax applied to the lesser of net investment income or the amount by which modified adjusted gross income exceeds specific thresholds. For 2025, these thresholds are $200,000 for single filers and $250,000 for married taxpayers filing jointly.
Taxation of Capital Gains
The taxation of capital gains also distinguishes between short-term and long-term holdings. Short-term capital gains are taxed as ordinary income, meaning they are subject to the same tax rates as wages, salaries, and other forms of regular income. These rates vary from 10% to 37% for the 2025 tax year, depending on the taxpayer’s overall income bracket. For example, if an individual in the 24% ordinary income tax bracket realizes a short-term capital gain, that gain will be taxed at 24%.
Long-term capital gains, however, benefit from preferential tax rates, similar to qualified dividends. These rates are 0%, 15%, or 20%, depending on the taxpayer’s taxable income. The specific income thresholds for these rates are identical to those applied to qualified dividends, as detailed in the “Taxation of Dividends” section.
Similar to dividend income, higher-income taxpayers may also be subject to the Net Investment Income Tax (NIIT) on certain capital gains. The 3.8% NIIT applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds the statutory thresholds, which are identical to those for dividend income.