Investment income is an umbrella term that includes just about any money you make from buying, holding and selling assets. However, there are three main forms of investment income, which we discuss below. Together these types of investment income are central to most retirement plans, every portfolio and even some people’s entire financial strategy. Consider working with a financial advisor as you evaluate your portfolio for its income-generating capacity.
What Is Investment Income?
Investment income is money you make by holding or selling financial assets and other property. You earn investment income when you sell a stock, collect interest on a bond, sell your house, or even just watch your savings account grow.
There are three main forms of investment income:
Capital gains
This is money that you make by selling an asset. For example, say you buy a stock and then sell it later for $100 more than you originally paid. This $100 profit would be considered capital gains. Losses, when you sell an asset for less than you originally paid, are not technically considered capital gains. Formally the term capital gains only applies to profits, although informally people use this term to refer to any money made by selling an investment asset. There are two types of capital gains, short-term and long-term, each of which is taxed differently.
Interest payments
This is money paid by a debt instrument such as a bond or a CD. For example, say you buy a bond with a 2% monthly interest payment. Each month you will get a payment for 2% of the bond’s value. This payment comes from the underlying borrower as a payment for lending them money.
Interest payments are fixed. They are paid in a regular amount on a regular schedule. The only variable is whether the underlying borrower will remain creditworthy. It is extremely important to understand that interest payments apply only to debt contracts. Interest and compound interest are not the same thing as general returns and compound returns and confusing the two can lead to significant misunderstandings.
Dividends
This is money paid by companies to their shareholders. For example, say XYZ Corp. chooses to share its quarterly profits. It might issue a dividend payment in the amount of $1 per share. In this case, everyone who holds XYZ Corp. stock will receive $1 for each share of stock in the company they own.
Unlike interest payments, dividends are not regular. A company may plan to issue them on a set schedule, but they are based entirely on corporate performance and leadership. Only shares of stock issue dividends.
An asset’s interest and dividends are called its yield. This refers to the active income that an asset generates while you own it. The total money you make off an asset, through capital gains, interest and dividends alike, is called its return.
Common Sources of Investment Income
Various types of securities provide various types of income. Some securities are designed to provide both dividends and capital gains; other securities are designed to provide both interest payments and capital gains. Yet other types of securities are designed to provide capital gains only. Combining the various types of securities in your investments is key to a well-balanced portfolio. Some of the most common sources of investment income include:
Stocks
Otherwise known as equities, each share of stock represents a fraction of ownership in the company which issued it. These generate income through capital gains (by selling the stock to another investor) and through dividends.
Bonds
These are shares of corporate or government debt. Each represents the face value of debt issued by the underlying entity. During the bond’s lifetime, the entity will make fixed-interest payments. At its expiration, the entity will pay the bond holder back the value of the bond. (Note that some bonds do not pay regular interest, but instead simply pay a larger sum at the expiration of the bond.)
Real estate
This is land and any structure on that land, such as homes, offices and other buildings. Generally speaking, real estate generates investment income through capital gains. In some circumstances the profit (such as rental payments) from real estate can be considered investment income, but typically this is considered earned income.
Funds
These are portfolios of assets and they include mutual funds and exchange-traded funds (ETF). The fund will hold a group of assets such as stocks, bonds and real estate as well as its overall value will reflect the average value of its holdings. Investors can buy a percentage of the fund in the form of shares and will receive a proportional share of the fund’s returns. They pay shareholders based on capital gains, interest and dividends received from assets in the fund.
Annuities and certificates of deposit
An annuity is a contract that you make with an insurance company. While there are various types of annuities, you generally pay up front and then the company makes regular payments to you plus a fixed rate of return. Certificates of deposit (CDs) are loans that you make to your bank, which are paid back again with a fixed rate of return. Both are common retirement vehicles and both provide investment income in the form of interest payments.
Earned vs. Owned Income
Investment income is one of the three main categories of income that someone can declare. These include:
- Earned Income – Money generated in exchange for work, such as salary, wages and contractor fees.
- Unilateral Income – Money generated in exchange for nothing. This covers transactions such as gifts, inheritances and prizes.
- Investment Income – Money generated in exchange for ownership. This is money that you make simply by dint of owning an asset or by selling that asset. This is otherwise known as “ownership income.”
The main difference between each category of income is taxes. The IRS taxes earned, unilateral and investment income differently.
In most cases, when an asset generates investment income it must have gained value either in whole or in majority part through the labor of others. For example, when a stock gains value, it does so because of the work put in by the company’s leadership and employees. As a shareholder, your only relationship was in buying and then selling this asset. This is part of the formal definition for when a product counts as a financial asset, or a “security,” to use the language of lawyers.
The reverse also holds true. In most cases when an asset gains value because of the work you put into it, selling it counts as earned income and is taxable. For example, if you buy a stock of lumber and turn it into a series of tables, the IRS would consider this earned income rather than investment income. Even though you made this money buying and selling wood, the same way you might make money buying and selling stocks, your labor created the added value.
While this is a good rule of thumb, it is not universal. For example, when you sell a business or a house any profits that you make are considered capital gains and taxed as investment income. This is true even if your labor gave the asset its value. If you built a small business and sold it, the value of this asset would come entirely through your work. The pay that you derived from it over the years would be considered earned income, but when you ultimately sell the business it will be taxed as investment income.
This gets most confusing in the area of passive vs. active income. Passive income is money that you make without working. It can include investments, but it also can include things like royalty payments, rental payments on property you own, long-term payments on a contract, debt payments and any other money you make without taking action. Determining whether a specific source of passive income is considered earned or investment must be done on a case-by-case basis.
Taxes and Investment Income
The most important reason to understand the nature of investment income is that it is taxed differently from other sources of income. Earned income, money that you work for, is taxed at the ordinary rate of income taxes based on your individual tax bracket. It is also subject to the payroll tax up to the first $142,800 that you earn in a year. (Unilateral income is a broad and messy topic, but is subject to a potential range of taxes depending on the source of the income.)
Investment income is typically not subject to the payroll tax and is subject to a range of potential tax rates. For capital gains on assets that you have held more than 12 months, the IRS taxes you at a lower rate than income that you worked for. This has a maximum rate of 20%. Capital gains on assets that you held for less than 12 months are taxed at the ordinary income tax rate, which is why there is often a flurry of trading every January.
Dividend income can sometimes be taxed at ordinary income rates, however it is typically taxed at no more than 15%.
Finally interest income is typically taxed as ordinary income. For a more thorough analysis of investment tax implications, see this briefing from the Tax Policy Center.
The Bottom Line
Investment income is the money you make from selling something valuable (capital gains), collecting interest payment on debt instruments or receiving dividend payments from stocks. It is often taxed at different rates than ordinary income and so is essential to understand.
Tips on Investing
- The best way to understand something complicated is by doing it. With our capital gains tax calculator, you can see exactly what the tax implications are for your portfolio before even making a move.
- What kind of investment income is right for you? That depends entirely on your personal financial strategy, and fortunately SmartAsset can help you develop one. With our free matching tool you can find a financial professional near you to help you build a strategy… and the portfolio to match it. If you’re ready, get started now.
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