What Is Investment Income?
Generally, most people earn most of their net income each year through regular employment income. However, disciplined saving and investment in the financial markets can grow moderate savings into large investment portfolios, yielding an investor a large annual investment income over time.
Interest earned on bank accounts, dividends received from stock owned by mutual fund holdings, and the profits on the sale of gold coins are all considered investment income. Income from long-term investments undergoes different—and often preferential—tax treatment, which varies by country and locality.
- Investment income is the profit that is earned from investments such as real estate and stock sales.
- Dividends from bonds also are investment income.
- Investment income is taxed at a different rate than earned income.
Businesses often have income from investments. On the income statements of publicly traded companies, an item called investment income or losses is commonly listed. This is where the company reports the portion of its net income obtained through investments made with surplus cash, as opposed to being earned in the company's usual line of business. For a business, this may include all of the above, as well as interest earned or lost on its own bonds that have been issued, share buybacks, corporate spinoffs, and acquisitions.
Understanding Investment Income
Investment income refers solely to the financial gains above the original cost of the investment. The form the income takes, such as interest or dividend payments, is irrelevant to it being considered investment income so long as the income is generated from a previous investment. Additionally, investment income may be received as a lump sum or in regular interest installments paid out over time.
Investment Income Made Simple
The interest accrued on a basic savings account is considered investment income. The interest is earned on top of the original investments, which are the deposits placed into the account. That makes the account a source of income.
Options, stocks, and bonds can also generate investment income. Whether this is through regular interest or dividend payments or by selling a security at a higher price than was paid for it, the funds above the original cost of the investment qualify as investment income.
Investment Income and Taxes
Most but not all investment income is subject to preferential tax treatment when the income is realized. The associated tax rate is based on the form of investment producing the income and other aspects of an individual taxpayer’s situation.
Many retirement accounts, such as a 401(k) or traditional IRA, are subject to taxation once the funds are withdrawn. Certain tax-favorable investments, such as a Roth IRA, are not taxed on eligible gains associated with a qualified distribution.
Meanwhile, long-term capital gains and qualified dividend income are subject only to a maximum federal tax of 20%, even if that amount exceeds a half-million dollars in a given year.
Compare that to the tax rates on earned income, which range from 12% to 37%. For tax year 2020, that 37% rate was levied for single taxpayers with incomes greater than $518,400 and married couples filing jointly with incomes over $622,050. For 2021, the threshold for the top rate is above $523,600 for individuals and $628,300 for married couples filing jointly.
Investment income can also be used in conjunction with an individual's earnings in order to provide income tax credits. For example, one of the criteria used to evaluate individuals for the Earned Income Tax Credit (EITC) is earning from running a small business and not having investment income over $3,500.
Real estate transactions can also be considered investment income, and some investors choose to purchase real estate specifically as a way to generate investment income—either from the cash flows generated from rents or from any capital gains realized when selling the property.
Once the original cost of the property is repaid by the investor, and rent payments received are not used for the purpose of covering other property-related expenses, the income qualifies as investment income.
Examples of Investment Income
Suppose an investor buys stock in company ABC for $50. Two weeks later, the investor sells them for $70, netting a profit of $20. This is a short-term investment, so the profit is taxed at the investor's regular earned income tax rate. (Federal tax law defines a short-term investment as one owned for less than a year.)
Suppose the same individual invests $500,000 in real estate property. The investor sells the property for $1.5 million 10 years later. The investment is categorized as long-term investment income and taxed at the long-term capital gains tax. The tax percentage depends on the overall income of the taxpayer. In 2020, that is zero on gains for taxpayers with incomes up to $53,600. It was 15% on gains between $53,601 and $469,050, and 20% on income above that level.