Dividends and interest are the two major types of income investors can receive. The distinction between dividends and interest is determined by what type or classification of investment pays the income. Dividends and interest also have different tax consequences for both the receiving parties and the paying entities.
Interest is the income received from bonds, bank CDs, saving accounts, bank money market accounts or loans made as a lender. Dividends are paid to shareholders of stock as a portion of the company profits and all investment company distributions are classified as dividends. Mutual funds, closed-end funds and Exchange-Traded Funds are the different types of investment companies. Interest income is reported to the individual and IRS on IRS Form 1099-INT and dividends are reported on IRS Form 1099-DIV.
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Interest received can fall into several different tax categories. Interest from municipal bonds is exempt from federal income tax. Interest from Treasury bills, notes and bonds is exempt from state income taxes. Other forms of interest income is taxable as regular income. Interest paid by corporations to bondholders is a tax-deductible expense to the corporation.
Dividends are classified as qualified or non-qualified. Qualified dividends are paid by regular corporations out of the company's net income. For investors, qualified dividends are taxed at the same low rate as long-term capital gains. Non-qualified dividends are from corporations organized under a pass-through provision of the tax code, such as real estate investment trusts (REITs). Dividends from investment companies, such as mutual funds, are qualified or non-qualified based on the source of the income to the fund. A fund that earns qualified corporate dividends will pay qualified dividends. A fund that earns taxable bond interest will pay non-qualified dividends. Funds that buy tax-exempt municipal bonds will pay dividends that are tax-exempt to the investor.
Many interest-paying investments pay a fixed rate of interest that cannot be changed. Bonds and bank CDs pay a steady rate until they mature. The payment of corporate dividends is decided by each company's board of directors. Corporations can increase, decrease or stop their dividend payouts at any time. Income investors must compare the steady interest payouts of bonds or bond funds to the less secure dividend payouts of high-yield stocks. Many dividend-paying corporations have a history of increasing the distributions as corporate profits increase over time.
Investors should compare both the potential income level and tax consequences before deciding on investments that pay interest or dividends. Corporate dividends may qualify for a lower tax rate and have the potential to increase over time. Interest from bonds or CDs is a legal obligation of the issuer and can be more stable and at a higher rate than dividend yields. Municipal bond interest may be paid at a lower rate but have a higher after-tax return for high-income taxpayers.