Dividend vs. Capital Gains Income. As discussed below, income from long-term capital gains generally receives more favorable tax treatment than dividend income. However, any capital gains that an investment may earn tend to be somewhat unpredictable and, in any case, must be deferred until at least some portion of the investment is sold.

Dividend income, on the other hand, while not necessarily completely certain, tends to be more predictable than capital gains and is generally received monthly or quarterly, so that it can be used to pay current expenses without selling the investment that generated it.

Taxation of Dividends. Investment dividends are normally taxed as ordinary income for federal and most state income tax purposes.

Therefore, a hypothetical 9% per annum dividend return would not be the same as 9% annual appreciation in a common stock, because there would be no tax consequences of holding the non-dividend paying stock and if held for at least one year, any capital appreciation in the value of the stock that is realized upon sale would be federally taxed at the time of sale at a 20% rate (but not higher than a taxpayer's ordinary income tax rate). Generally for assets disposed of after December 31, 2002, that have been held for at least 5 years, a maximum 18% federal long-term capital gains tax rate will apply.

The U.S. Congress has under consideration a proposed a change in the income tax treatment of dividends, to reduce or eliminate the tax to shareholders on dividends paid by taxable corporations. However, it is uncertain whether any such provision will become law.

Equivalence between Dividends and Capital Gains. If one makes some convenient assumptions, it is possible to compare after-tax earnings investments from dividends and from capital gains. The following table shows for each federal income tax bracket the annual price appreciation that one would need to earn on an investment in a non-dividend paying common stock to be equivalent to a portfolio of investments that pays a quarterly taxable dividend return of 9% per annum. No allowance is made in the table for the effect of state income taxes.

Annual Stock Price Appreciation Equivalent to a
9% Quarterly Taxable Dividend Yield

It is interesting to note that for persons in the 15% tax bracket and below, equivalent to a joint married taxable income of $46,700 or less in 2002, it is actually necessary to achieve a higher rate of annual appreciation than the stated return, because of the compounding effect of quarterly dividends.

The foregoing table also ignores the effect of market price changes in the dividend paying investments. If the investments were to increase in value then total return would exceed the dividend yield, whereas if they were to decline in value, the total return would be less than the dividend yield.  The table also ignores any alternative 18% capital gains tax rate that may apply to investments held at least 5 years.