When it comes to making money in the markets, investors have two main ways: capital gains and investment income. A capital gain is when an investment rises to a higher price than an investor paid. In contrast, investment income consists of payments such as dividends and interest as well as realized capital gains. How these sources of income are taxed differs, too.

Here are other key similarities and differences between capital gains and investment income.

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. Investors can hold on to their unrealized capital gains and avoid tax indefinitely.

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, as well as from realized capital gains. 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. And if an investor sells a stock with a gain and realizes that gain, then it legally counts as investment income and becomes taxable.

Whereas capital gains come from selling an investment at a higher price, investment income derives from a company’s earnings. When a company turns a profit, it may distribute some of its profit as dividends or it may pay interest on any outstanding bonds.

For example, going back to our $30 stock, the company may decide to distribute some of its profits to them because it no longer needs to invest them in the business. It then chooses to pay a certain amount of cash to every outstanding share.

Let’s assume the stock pays a quarterly dividend of $0.25 per share. So the annual dividend would be $1.00 per share. So each quarter the investor receives:

$0.25 * 10 shares  = $2.50

The total annual dividend is:

$2.50 * 4 = $10.00

At a price of $30, the stock yields a dividend of 3.3 percent.

Important tax considerations

The circumstances for taxing capital gains and other types of investment income differ.

Dividend taxes

Dividends may be taxed in a couple different ways, depending on whether they’re ordinary dividends or qualified dividends.

  • Ordinary dividends are taxed at ordinary income rates.
  • In contrast, qualified dividends receive more favorable treatment at what may be lower tax rates. But you will need to hold the stock for more than 60 days during the 121-day time period beginning 60 days before the stock’s ex-dividend date (for common stock.) The ex-dividend date is when the stock price is adjusted lower to factor in the dividend. For preferred stock, the dividend is qualified if you hold it for more than 90 days in the 181-day period that begins 90 days before the ex-dividend date.

Qualified dividends are taxed at rates of zero, 15 and 20 percent, depending on the tax filer’s income.

And unlike unrealized capital gains – which do not create a tax liability – dividends are taxable for the tax year they’re received, if they’re in a taxable account. 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 in a couple 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 at ordinary income rates.
  • 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 2023.

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 $89,250 in 2023. Moreover, skillful maneuvering can allow you to earn more than $100,000 and owe no taxes.

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.

Bottom line

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.