Capital gains vs. investment income: How they differ
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When it comes to making money in the markets, investors have two main ways: capital gains and investment income. Stock from a single company can provide profit in both forms, but how each works is different. Taxes also work differently for capital gains and investment income.
A capital gain is when an investment rises to a higher price than an investor paid. On the other hand, investment income comes from payments in the form of dividends or interest.
What are capital gains?
Capital gains refer to an increase in the value of an asset, such as a stock or a bond. If the investor sells that appreciated asset, it creates a realized capital gain, which is taxable. If the asset remains unsold, then the capital gain is unrealized and capital gains tax is deferred.
For example, suppose an investor buys 10 shares of stock in their favorite shipping company at $25 per share. Their total investment in that company is $250. The company has a good year, and the stock price rises to $30, meaning the investor now has an investment with a $300 market value.
In this example, the capital gain is $50. If the investor decides to sell the shares, they would realize the capital gain and owe tax. If they decide to hold on, their capital gain will not be taxed.
Some investors hold appreciated stock for decades and never owe capital gains tax.
What is investment income?
Investment income comes from direct payments to investors, typically in dividends or interest. For instance, some stocks pay dividends on a consistent schedule, such as once per quarter or monthly. Interest may come from bonds, which typically make their payouts semiannually.
Whereas capital gains come from selling an investment at a higher price, investment income is from company earnings. In other words, when a company turns a profit, it rewards investors by distributing some of its profit as dividends or interest on its bonds.
For example, going back to our $30 stock, the company may decide to start rewarding investors by distributing some of its profits to them. It does this by dividing the share of its profits it wants to share with investors by the number of outstanding shares.
Let’s assume the stock pays an annual dividend of 3 percent, which is a typical level for strong dividend stocks. So the annual dividend would be $0.90 per share. The company pays dividends quarterly, so each quarter the investor receives:
$0.90 * 10 shares / 4 = $2.25
The total annual dividend is:
$2.25 * 4 = $9.00
Important tax considerations
Both investment income and capital gains may be taxed. However, the tax rates for each differ.
Dividends may be taxed in a couple different ways, depending on whether they’re ordinary dividends or qualified dividends. Ordinary dividends are taxed as ordinary income. However, qualified dividends receive more favorable tax treatment at what may be lower tax rates.
Capital gains taxes
Realized capital gains are also treated in a few different ways, depending on how long the asset was held and how much income the investor has.
- Selling an investment after holding it less than a year results in a short-term capital gain, which is taxed as ordinary income.
- Selling an investment after holding it more than a year results in a long-term capital gain, which is taxed according to separate long-term capital gains tax rates. Different tax rates apply depending on your income.
Long-term capital gains tax rates are often lower than ordinary income tax rates. Capital gains are taxed at rates of zero, 15 and 20 percent, depending on the investor’s total taxable income. That compares to the highest ordinary tax rate of 37 percent for 2022.
The capital gains tax rates are highly advantageous. In fact, a married couple filing jointly has a 0 percent capital gains tax rate if their taxable income is up to $83,350 in 2022.
It’s worth noting that investors can also write off losses from their investments, and may offset their gains with any losses. The process – called tax-loss harvesting – can save investors significant money when it comes time to pay taxes.
Net investment income tax
Finally, 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
Generally, the main way to avoid taxes on your 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. Of course, an investor can hold appreciated stock indefinitely and never pay any capital gains tax.
Capital gains and investment income are two ways that investors can make money on their investments, and they each are treated differently for tax purposes. So it can make sense for investors to understand which approach to making money works better for their financial needs.