Capital Gains vs. Investment Income: An Overview
The difference between capital gains and other types of investment income is the source of the profit. Understanding the difference is important in terms of everything from filing taxes to planning a retirement strategy.
Capital refers to the initial sum invested. A capital gain, therefore, is the profit realized when an investment is sold for a higher price than the original purchase price. Investment income is profit that comes from interest payments, dividends, capital gains collected as a result of the sale of a security or other assets, and other profits made through an investment vehicle of any kind.
Gains are distributed among multiple investors in specific ways depending on how investments were made. Here's a look at the difference between capital gains and investment income.
- Capital gains and other investment income differ based on the source of the profit.
- Capital gains are the returns earned when an investment is sold for more than its purchase price.
- Investment Income is profit from interest payments, dividends, capital gains, and any other profits made through an investment vehicle.
- Capital gains taxes have either a short-term or long-term classification depending on if the holding was more than a year.
A capital gain is an increase in the value of a capital asset—either an investment or real estate—that gives it a higher value than the original purchase price. An investor does not have a capital gain until an investment is sold for a profit.
For example, let's assume an investor has purchased 100 shares of stock in company ABC at $10 per share. The capital expenditure (CapEx), therefore, is $10 x 100, or $1,000.
Now assume the value of each share increases to $20, making the total investment worth $2,000 ($20 x 100 = $2,000). If the investor sells the shares at market value, the total income is $2,000. The capital gain on this investment is then equal to the total income minus the initial capital ($2,000 - $1,000 = $1,000).
Individuals mostly earn net income through employment income, but investing in the financial markets can also yield additional income, called investment income. Some investment income is attributable to capital gains. However, the income that is not a result of capital gains refers to earned interest or dividends.
Unlike capital gains, the amount of return for these investments is not reliant on the initial capital expenditure. In the capital gains example, assume company ABC pays a dividend of $2 per share for each of the 100 shares that the investor purchased. If dividends are paid before the sale of shares, the investment income generated is $2 x 100, or $200.
Using a different example, a savings account totaling $5,000 with a 6% annual interest rate will generate investment income totaling $300 ($5,000 x 0.06 = $300) in its first year.
One key difference between capital gains and other types of investment income is the rates at which they are taxed. Tax rates vary depending on the kind of investment, the amount of profit generated, and the length of time the investment is held.
Capital gains are classified as short-term if they are realized on an asset that was held for less than a year. In this case, short-term capital gains would be taxed as ordinary income for that tax year. Assets held for more than a year, before being sold, would be considered to be long-term capital gains upon sale.
The tax is calculated only on the net capital gains for that tax year. Net capital gains are determined by subtracting capital losses—income lost on an investment that was sold at less than what it was purchased for—from capital gains for the year. Most investors will pay a capital gains tax rate of less than 15%.