Capital Gains vs Investment Income: Main Differences

Investors looking to make money in the markets have two primary options: capital gains and investment income.

Capital gains occur when an investment increases in value, while investment income includes payments like dividends, interest, and realized capital gains.

It’s important to note that these sources of income are taxed differently, adding another layer of complexity to the decision-making process.

To better understand the similarities and differences between capital gains and investment income, it’s essential to examine key factors such as taxation, risk, and potential returns.

This article will delve into these topics and provide a comprehensive overview of the two investment strategies.

What Are Capital Gains?

Capital gains are the profits made from selling an asset that has increased in value. This can include stocks, bonds, real estate, and other investments.

When an investor sells an asset for a higher price than they initially paid for it, they have realized a capital gain. The amount of tax owed on the capital gain depends on how long the investor held the asset and their income tax bracket.

For example, if an investor purchased 10 shares of stock in a shipping company for $25 per share, their total investment would be $250. If the stock price rises to $30 per share, the investor’s investment now has a market value of $300, resulting in a capital gain of $50. If the investor decides to sell the shares, they would owe tax on the realized capital gain.

However, if the investor decides to hold on to the shares, their capital gain remains unrealized, and they can avoid paying capital gains tax indefinitely. Some investors hold on to appreciated stock for decades without ever owing capital gains tax.

In summary, capital gains are the profits made from selling an asset that has increased in value. The tax owed on capital gains depends on how long the investor held the asset and their income tax bracket.

What is Investment Income?

Investment income refers to the money earned by an investor from their investments. Investment income can come in the form of dividends, interest, or realized capital gains. Dividends are a portion of a company’s earnings that are distributed to its shareholders.

Interest is paid to bondholders as compensation for lending money to a company. Realized capital gains are profits made from selling an investment at a higher price than it was purchased for.

For instance, let’s say an investor owns 10 shares of a company that pays a quarterly dividend of $0.25 per share. The investor would receive $2.50 every quarter, or $10.00 annually. Dividend yield is calculated by dividing the annual dividend by the stock price. In this case, the stock yields a dividend of 3.3 percent.

Realized capital gains occur when an investor sells a stock for a profit. This profit is considered investment income and is taxable. Investment income is an important aspect of investing, as it can provide a steady stream of income and increase overall portfolio returns.

Important Tax Considerations

Dividend Taxes

Dividend taxes are a significant consideration for investors. Ordinary dividends are taxed at ordinary income rates, while qualified dividends receive more favorable treatment at potentially lower tax rates.

However, to qualify for the lower tax rates, the stock must be held for more than 60 days during the 121-day period beginning 60 days before the stock’s ex-dividend date (for common stock).

For preferred stock, the dividend is qualified if held for more than 90 days in the 181-day period that begins 90 days before the ex-dividend date. The tax rates for qualified dividends are zero, 15, and 20 percent, depending on the investor’s income. Dividends in tax-advantaged accounts such as an IRA or 401(k) do not create a tax liability in the year they’re received.

Capital Gains Taxes

Realized capital gains are also treated differently depending on how long the asset was held and how much income the investor has. Short-term capital gains, which result from selling an investment after holding it less than a year, are taxed at ordinary income rates.

Long-term capital gains, which result from selling an investment after holding it more than a year, are taxed according to separate long-term capital gains tax rates. These rates are often lower than ordinary income tax rates and range from zero to 20 percent, depending on the investor’s total taxable income.

Additionally, a married couple filing jointly has a 0 percent capital gains tax rate if their taxable income is up to $89,250 in 2024. Investors can also write off losses from their investments and may offset their gains with any losses, saving significant money when it comes time to pay taxes.

Taxes on Interest Income

Interest income is generally taxed as ordinary income, meaning it’s subject to the same federal tax rate as your income. This applies to interest earned from bonds, savings accounts, and certificates of deposit.

However, interest from state-issued municipal bonds may be tax-exempt if issued in your home state. Regardless of whether interest income is taxable or tax-exempt, it must be recorded on your tax return using Form 1099-INT.

Interest generated on tax-deferred accounts like traditional IRAs or 401(k)s doesn’t require reporting until you withdraw the funds.

Net Investment Income Tax

Income from dividends, capital gains, and other similar forms of income may face an additional surcharge of 3.8 percent, called the net investment income tax. The assessment of this surcharge depends on the investor’s income and filing status.

Tax-Free Capital Gains and Dividends

The main way to avoid taxes on capital gains and dividend income is to own these assets in tax-advantaged accounts such as a 401(k) or an IRA, especially a Roth IRA. Alternatively, an investor can hold appreciated stock indefinitely and never pay any capital gains tax.

Conclusion

Investors should understand the tax implications of capital gains and investment income.

Depending on their financial goals, one approach may be more advantageous than the other. It’s important to consult with a financial advisor to determine the best strategy for each individual’s unique situation.

Leave a Comment