A few years ago, I started investing small amounts without a full understanding of the different performance metrics. My knowledge was limited and I couldn’t project how or when I’d be taxed on my returns. I also didn’t understand how the decisions I made played a role on how much I would pay. Depending on whether you earn dividends or capital gains, you may get taxed at different times and may also pay different rates, and it’s important to consider both as you evaluate your return on investment compared to other opportunities.
Recently, I have started to invest in index funds to reduce the amount I pay in management fees. I make money from these funds through both dividends and capital gains to provide income to my future self. By understanding how these are calculated, I can better understand how my portfolio is performing, understand what to expect for passive income in the future, and ultimately how much to expect to pay in taxes. Full disclosure, I recommend following up with a certified professional as you look to apply my lessons learned to your unique scenario.
If you are saving for financial independence, it can be especially valuable to understand how your current decisions are affecting your portfolio growth and understand how your future income will be taxed (or how you are taxed today) if you expect your annual income to change.
What are Dividends and Capital Gains?
When a company makes money, they can either take the revenue to reinvest in their business for growth, or they can pay out dividends to their shareholders. Reinvesting in their business theoretically is recognized through a higher stock market price in the future, however isn’t guaranteed. When a company or mutual fund pays out dividends to their shareholders, you see that transaction monthly, quarterly, or annually and can choose to reinvest that cash back into the fund.
Dividends: Cash paid out to you regularly (monthly, quarterly, or yearly for example). You have the ability to keep the cash, or you can reinvest into the fund you have selected. For example, if you own 5 shares and the dividend payout is $1 per share, you will collect $5. While dividends are not guaranteed, you receive a cash value and doesn’t depend on future performance to receive that cash today.
Capital Gains: Money recognized when the value of the stock you have purchased increases. For example, if a stock was worth $20 when you purchased it, but is now worth $30, your capital gains are $10 per share. Similar to dividends, capital gains are not guaranteed and rely on the value of the stock to increase so that when you sell the stock in the future, it will be worth more than you paid for it.
When I first started to invest, I was focused on the historical capital gains in hopes that prior performance may predict what I could expect in the future. I may have also typed “best mutual funds” into google to kick start my search. Obviously, past performance is never a guarantee of future performance, but focusing on the capital gains drastically underestimates the gains from dividends, changing how your selection compares to alternative investment opportunities.
Value to Shareholder = Capital Gains + Dividends
Say for example, a fund shows a historical dividend pay out of $1 per share and the share is worth $200. If that dividend payout is quarterly, then the dividend yield you would see is calculated as the annual return for the share value or $4/$200 = 2%. Note that the dividend yield will depend on how many times a dividend is paid out during the year to calculate the annual income. Now if that stock increases in value by 5% over the year, then you can expect a 7% return (2% through dividends and 5% through capital gains). Keep in mind that if you are paying management fees or pay commission fees, you will need to account for them to understand your true return on investment.
Have you given much thought on a preference between dividends and capital gains? While you’re building up your portfolio, it may not seem like a significant difference as long as you are reinvesting your dividend payouts and ultimately make money. Maybe you prefer the dividends because you feel like you get the cash now versus waiting for future returns or have a higher sense of confidence that dividends will pay out even if the stock value drops.
How are Taxes Calculated?
The first time I received my 1099 forms to report my investment income, I didn’t know exactly what the numbers were telling me or how they would impact my taxes for the current year. For example, one of the first years I decided to sell some of my shares to help pay for our wedding. At quick glance, my 1099 gave the impression that it was a really good year! I’ve since taken some time to learn more about how dividends and capital gains are taxed so I’m not surprised and can calculate how my decisions now will affect my taxable income later. The ability to estimate your taxes can be especially beneficial if you anticipate your income changing in the future so you don’t pay more than you should have to.
For starters, some dividends and capital gains apply to a more favorable tax bracket, and you can expect to pay a different tax scale depending on when you sell your shares for capital gain. If you sell in less than a year, the income is considered short term capital gain and will apply to your federal income tax bracket for the year you sell. If you sell after one year then you will pay a more favorable tax bracket for long term capital gains. The chart below shows the details, but the favorable tax rate is 0% until you earn over $40,000, at which point you only will pay 15% until you earn over $441,450. Compared to the federal income tax rates, you could easily save up to 12% of your income by ensuring your capital gains apply to the more favorable rate. NerdWallet has a helpful calculator where you an put in your current income and anticipated capital gains to see what tax bracket will apply for your unique situation.
|Income Level||Federal Income Rate||Favorable Rate|
|$9,526 to $39,375||12%||0%|
|$39,476 to $84,200||22%||15%|
|$84,201 to $160,725||24%||15%|
Second, if you anticipate your income being lower in the future, you may want flexibility on the year you are taxed so that you pay at the lower rate. For example, many who achieve financial independence anticipate a lower annual income after they “retire.” When you earn dividends, you pay taxes on them the year you earn them. However, capital gains will not be taxed until you actually sell the shares you own. That means your dividends may be taxed at a higher rate if your annual income is higher today. Your capital gains could be taxed at a lower rate if you don’t sell them until your income lowers.
|Income Type||Tax Rate Paid||When Taxes Paid|
|Qualified Dividends||Favorable (0%, 15%, 20%)||Annually when Received|
|Non- Qualified Dividends||Income Tax Bracket||Annually when Received|
|Short Term Capital Gains||Income Tax Bracket||Annually when Sold|
|Long Term Capital Gains||Favorable (0%, 15%, 20%)||Annually when Sold|
Real Life Scenario:
Let’s say that you currently earn $60,000 a year and you anticipate your future income to be $30,000 when you will be supplementing or fully living on your investment gains. You selected a fund that provides shareholder value through non-qualified dividends. You pay taxes on your dividends when you receive them and your current taxable income rate up to 22%. If alternatively you had selected a fund that provides shareholder value through increased stock price, you can sell shares for capital gain when your income is $30,000. By ensuring you apply for the favorable tax rate and selling your shares when your income is lower, you could pay 0%. Let’s say you have $150,000 currently invested and expect a 2% dividend yield, so you earn about $3,000 a year in dividends. Seeing that income on your 1099 form feels great, but you are accountable for $660 ($3,000 x 22%) in taxes this year when you could pay as little as $0 if you had planned differently.
At the end of the day, it’s important to diversify your portfolio appropriately, however understanding the true value of your investment returns and how they will be taxed, may change the decisions you make on where to invest or whether to sell to reallocate your portfolio.
- Your investment returns are comprised of dividend payouts and capital gains.
- You can pay a more favorable take rate by holding onto your investments until they quality as long term capital gain.
- If you expect your income to change, you may appreciate the flexibility to sell your shares for capital gains the year you want to pay taxes on your future income.
- If you expect your income to change, you may want to consider the income taxes you are paying for your annual dividends at your current salary.
- Not all dividends are taxed equally and qualified dividends apply for a more favorable tax rate.
- Consider how your choices will affect your taxes when you are buying and selling investment options today and in future years.
How do you consider the split between anticipated capital gains and dividends in your investments? Comment below, I’d be interested to hear your perspective!
Some references I checked out when researching this topic:
- Understanding Long Term vs Short Term Gains (Investopedia)
- Is Dividend Income Taxable? (Investopedia)
- Capital Gains Tax Rates and Calculator (NerdWallet)
Interested in future posts published weekly? Sign up below: