Best Form of Return: Capital Gains vs. Dividends

Shares CertificateWhich is the best form of return, capital gains or dividends? Capital gains are the money that you get from selling any asset for more than the amount you paid for it. If you buy a car, fix it up, and sell it for a profit, you have to pay capital gains on the profit. Stocks, bonds, and other financial instruments are no different, though you can’t buy parts for them at the store.

Stocks, however, are actual pieces of a corporation that makes money for you. The whole point of a corporation is that it runs separately from its owners. If you own a business on your own or as a partnership, anytime the business makes money from an accounting perspective, you have to pay tax on it, regardless of whether any cash was involved. Corporations recognize their own income and pay their own taxes.

You don’t pay taxes until the board of directors issues a dividend and sends you a check so that you can pay income tax on it. Yes, the money is taxed twice. That’s part of the price of not risking more than your investment. If the company goes under, the creditors won’t come take your house.

Most corporations do not distribute all of their earnings. Some never pay dividends, especially if the business is growing. If they did they would have to finance their growth through borrowing or selling more stock, both of which come at a price. Just financing from inside is cheaper. When a company does this, the stock is worth more. Your return comes from the increase in the stock price, which you realize only when you sell the stock.

There are ongoing arguments in the financial world about which kind of policy, dividends or internal growth that leads to capital gains, is the best option. The type of company has something to do with it. But even a company that has reached its growth potential can choose buy back its own stock to increase the value of the remaining stock.

The truth is, the dividends or capital-gains choice has more to do with the type of investor than anything else. Investors that are in low tax brackets, such as retirees or kids with money in trusts, like dividends because they don’t pay as much tax as most investors. In fact dividend-payers are historically called widow and orphan stocks. If the market is basing its required rate of return on a 35% tax rate, and someone is only paying 10% on the income from the dividends is getting a bonus.

Investors with a higher tax rate have the opposite wish. They want capital gains so that they can control the timing of the income realized and tax paid. If a stock in a portfolio goes down and is sold, the investor can sell a stock that has gained in price at the same time so that the loss and gain cancel out and no tax is due. Taxes can also be deferred into the future, such as retirement, when the tax rate will be lower. Such stocks can also be donated rather than cash so that there is special tax consideration

The only bad thing about relying on capital gains is that it can encourage management to make unwise mergers. It will look like management is reinvesting your money. But unless there is a strong synergy between the two companies, there often is no particular benefit except increasing the compensation of the managers. Let the capital-gains-seeking buyer beware.

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