A dividend represents a portion of a company's earnings that the board of directors votes to pay to the company's shareholders. Companies that pay regular dividends in both good and bad economic times are typically mature, well-established firms and are sometimes referred to as Blue Chip companies. Not all companies pay dividends. The boards of directors of companies that are more focused on growth might choose to plow profits back into the company, but that doesn't mean you can't make money on their stock.
The Internal Revenue Service treats almost everything you own, whether for personal reasons or investment purposes, including stocks, as a capital asset. Your stock can increase or decrease in value. If you sell your non-dividend paying stocks for a higher price than you paid for them, you make money. The IRS refers to that as a capital gain.
Dividends are taxed as ordinary income in the year you receive them. Capital gains are also taxed in the year you receive them, but they could be taxed at different rates, depending on how long you held your stock. The IRS treats gains from stocks that you held for one year or less as short-term capital gains, which are taxed as ordinary income. Gains from the sale of a stock you held for longer than one year are considered long-term capital gains and are typically taxed at the more advantageous long-term capital gains tax rate.
Covered Call Options
Three things can happen to the market price of your stock: it can go up, it can go down, or it can stay the same. If you suspect the market price of your stock is going to drop, you will probably sell it to avoid taking a loss. If you suspect the market price is going up, you probably will hold it to take advantage of the increase. If you suspect the market price is going to stay the same or trade in a narrow price range, you can still make money by selling covered call options. When you sell a covered call option you get paid a premium to agree to sell your stock at a set price, called the strike price, for a specific period of time. If the stock price rises above the strike price and the option is exercised, you get the price per share of the strike price and you get to keep the premium. If the stock price does not rise above the strike price, the option will usually expire unexercised, and you get to keep both your stock and the premium.
Tax treatment for the premium you receive for selling a covered call option depends on whether the option was exercised or expired unexercised. The IRS treats the premium you received for a covered call option that expired unexercised as ordinary income. If the option was exercised, you must add the amount of the premium to the amount you received for the sale of the underlying stock. Any gain that results from the sale, including the premium, is considered long-term or short-term based on how long you owned the underlying stock.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.