Introduction

When you consider investing in the stock market, mutual funds, or real estate, you seek returns to increase your wealth. Not all returns are the same. Your investments can often reward you with capital gains or dividend income. Knowing the difference between the two and determining which is more favourable, capital gains or dividends, will help you make better investment decisions that fit your financial objectives. In this article, we will discuss the difference between the two gains.

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What are Capital Gains?

With capital gains, when you sell an asset such as shares, mutual funds, or property, you earn money, and the profit is termed a capital gain. For example, if you buy a stock for ₹1000 and later sell it for ₹1500, the capital gain will be ₹500. Note that capital gains are only realised when you sell the asset, meaning you do not see actual cash until the sales transaction is complete.

In India, capital gains can be either short-term or long-term. Gains attributable to shares of equity (including equity-oriented mutual funds) can either be short- or long-term; for gains to qualify as short-term, the asset must be held for less than one year. Short-term capital gains (STCG) are taxed at 15%. If you have held for over a year, it's long-term, and gains above ₹1 lakh are taxed at 10% (without indexation). For other assets like debt funds or real estate, the holding period for LTCG is two years, with a 20% tax rate after indexation, which adjusts for inflation.

The good thing about capital gains is their high potential return, especially in a bull market. However, with that potential return comes market risk, and you will have to time your entry and exit points into the market to grow gains.

What Is Dividend Income?

Dividend income is entirely different from capital gains. This is money paid to you by a company when it shares a portion of its profits with its shareholders. You can think of dividends as a reward for owning the company's stock. Most dividends are received quarterly or annually and paid to you without selling the shares. For example, if you had 100 company shares that declared a dividend of ₹5 per share, you would receive ₹500 back in your bank account.

In India, dividends are taxed in your hands as "income from other sources" and taxed at your slab rate. If you happen to be in the 30% tax bracket, you will pay tax at 30% on your dividend income. If dividend income exceeds ₹5,000 in any financial year, companies may deduct 10% tax at source (TDS), which you can claim back when filing taxes.

Dividends are attractive features of an investment. They earn you regular cash flow, which is good if you are looking for passive income. Not every company pays dividends; when times get tough, companies that pay dividends might reduce or eliminate their dividend payment.

Key Distinctions Between Capital Gains and Dividends

Here are the key differences:

• Timing of Returns: You do not receive capital gains until you sell the investment; you have cash flowing in periodically from dividend income without any action from you.

• Tax Advantages: Capital gains are taxed at a lower rate (10-15% if they are from equities) compared to dividend income, which is generally taxed at your income tax slab rate, which is likely over 30%. Capital gains are also much more tax-efficient for higher-income taxpayers.

• Risk and Reward: Capital gains are based on the market going up and down, offering greater potential gains but also more potential risk. Dividends are more stable (especially if you receive dividends from blue-chip companies), but they typically offer better returns.

• Control: You control when to realise capital gains by selling, providing flexibility. With dividends, you're at the mercy of the company's willingness to distribute profits, which you have no control over.

Which is Better: Capital Gains or Dividends?

If you are young, have a long investment horizon, and are okay with the market's ups and downs, capital gains may work better for you. Capital gains are an effective way to build wealth, particularly in a growing economy like India's, where stocks have returned well over time, including those in the Nifty 50. Numerous empirical studies suggest capital gains are an effective way to build wealth. The lower tax rates on LTCG are also attractive for long-term investors.

On the other hand, if you're closer to retirement or need a steady income flow to cover monthly or living expenses, you'll be better off focusing on dividends. Dividend-paying stocks provide a consistent cash flow that can be reinvested or used for living expenses. Stocks of companies that pay dividends, such as those in areas like FMCG or banking, are generally the stocks you want. The good thing about dividend-paying stocks is that they are typically less volatile than others.

Finding the Right Fit for You

There is no right or wrong answer. Many smart investors do both. You can invest in some growth stocks for capital gains and other investments with dividend income. You can even invest in mutual funds or ETFs that deal with growth and dividends, allowing for exposure to both.

But before deciding, consider your goal, risk tolerance, and tax situation. It can also be beneficial to speak with a financial planner to ensure your investments suit your situation, especially since tax rules in India can change. Understanding capital gains and dividend income equips you to build wealth that works for you.