When it comes to making money in the markets, investors have two primary means: capital gains and investment income. Shares of the same company can generate profits in both forms, but the way each works is different. Taxes also work differently for capital gains and investment income.
A capital gain occurs when an investment achieves a price higher than that paid by an investor. 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 bond. If the investor sells this appreciated asset, it creates a realized capital gain, which is taxable. If the asset remains unsold, the capital gain is not realized and capital gains tax is deferred.
For example, suppose an investor buys 10 shares of his favorite shipping company at $25 per share. Their total investment in this business is $250. The company is having a good year and the stock price rises to $30, which means the investor now has an investment with a market value of $300.
In this example, the capital gain is $50. If the investor decides to sell the shares, he will realize the capital gain and will have to pay tax. If they decide to keep, their capital gain will not be taxed.
Some investors hold popular stocks for decades and never owe capital gains tax.
What is investment income?
Investment income comes from direct payments to investors, usually in the form of dividends or interest. For example, some stocks pay dividends on a consistent schedule, such as once a quarter or once a month. Interest can come from bonds, which generally make their payments semi-annually.
While capital gains come from the sale of an investment at a higher price, investment income comes from the profits of the business. In other words, when a company makes profits, it rewards investors by distributing part of its profits as dividends or interest on its bonds.
For example, by returning to our $30 stock, the company may decide to start rewarding investors with a portion of its earnings. To do this, he divides the portion of his profits he wants to share with investors by the number of shares outstanding.
Assume the stock pays an annual dividend of 3%, which is a typical level for high-dividend stocks. The annual dividend would therefore 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
Investment income and capital gains may be taxed. However, the tax rates for each differ.
Dividend taxes
Dividends can be taxed in different ways, depending on whether they are ordinary dividends or qualified dividends. Ordinary dividends are taxed as ordinary income. However, eligible dividends receive more favorable tax treatment at what may be lower tax rates.
Capital gains tax
Realized capital gains are also treated in different ways, depending on how long the asset has been held and the income of the investor.
- Selling an investment after holding it for less than a year results in a short-term capital gain, which is taxed as ordinary income.
- Selling an investment after holding it for more than a year results in a long-term capital gain, which is taxed at 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 tax rates. Capital gains are taxed at rates of zero, 15 and 20%, depending on the investor’s total taxable income. This compares to the highest ordinary tax rate of 37% for 2022.
Capital gains tax rates are very favorable. In fact, a married couple filing jointly has a 0% capital gains tax rate if their taxable income reaches $83,350 in 2022.
It should be noted that investors can also amortize losses from their investments and can offset their gains with losses. The process – called tax loss harvesting – can save investors a lot of money when it comes time to pay taxes.
Net tax on investment income
Finally, income from dividends, capital gains and other similar forms of income may be subject to an additional 3.8% surtax, known as net investment income tax. The assessment of this surcharge depends on the investor’s income and filing status.
Non-taxable capital gains and dividends
Generally, the primary way to avoid taxes on your capital gains and dividend income is to hold 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 stocks indefinitely and never pay capital gains tax.
At the end of the line
Capital gains and investment income are two ways investors make money on their investments, and they are each treated differently for tax purposes. It can therefore be a good idea for investors to understand which approach to making money best meets their financial needs.
