Portfolio income is money received from investments, dividends, interest, and capital gains. Royalties received from investment property also are considered portfolio income sources.

It is one of three main categories of income. The others are active income and passive income.

Most portfolio income gets favorable tax treatment. Dividends and capital gains are taxed at a lower rate than earned income. In addition, portfolio income is not subject to Social Security or Medicare taxes.

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Alternative Income ETFs and Your Portfolio

Understanding Portfolio Income

Of the three categories, active income is the easiest to understand. It is money earned by doing a job or performing a service. The Internal Revenue Service (IRS) calls it wages, salaries, and tips.

Key Takeaways

  • Portfolio income includes dividends, interest, and capital gains.
  • Portfolio income generally gets favorable tax treatment compared to active or passive income.
  • Portfolio income is not subject to Social Security or Medicaid withholding.

It's a little trickier to distinguish portfolio income from passive income.

Passive income is a revenue stream that may involve some initial effort or expenditure but continues to reap payments down the line. Music and book royalties and property rent payments are examples. The interest on savings accounts is passive income. A limited partnership, in which an individual owns a share of a business but does not participate in its operation, produces passive income.

Investing in an ETF that buys dividend-paying stocks is one way to increase portfolio income.

Portfolio income does not come from passive investments and is not earned through regular business activity. It comes from dividends, interest, and capital gains, or from interest paid on loans.

The categories of income are important for tax purposes. Losses in passive income generally cannot be offset against active or portfolio income.

3 Ways to Increase Portfolio Income

Purchase High-Paying Dividend Stocks

Investors can increase their portfolio income by buying stocks that pay above-average dividends.

Dividends can be paid directly to the shareholder or used to purchase additional shares in the company, referred to as a dividend reinvestment plan (DRIP). For example, a company may pay a cash dividend of $2 per share annually. If the investor has a holding of 200 shares, the cash dividend payment would be $400 ($2 x 200 shares).

Purchase Dividend Exchange-Traded Funds

Buying ETFs that specifically track high-paying dividend stocks is a cost-effective way to increase portfolio income. For example, the Vanguard High Dividend Yield ETF tracks the FTSE High Dividend Yield Index. The index includes 396 stocks that have high dividend yields.

The selection criteria for other dividend ETF choices may focus on how many consecutive years the company has paid a dividend or on companies that have a history of increasing their dividend payments each year.    

Write Options

An investor can increase portfolio income by writing call options against their stock holdings.

For example, suppose an investor owns 100 shares of Microsoft and the stock is trading at $175 per share. The investor could agree to sell the shares if the stock rises 10% to $192.50. To do this, the investor sells 1 call option with a strike price of $192.50 at $2.

The investor would receive an option premium (portfolio income) of $200 ($2 x 100 shares). On the day the option expires, it becomes worthless if Microsoft is trading below $192.50, allowing the investor to keep the premium with no further obligation. However, If Microsoft is trading above the strike price on the day the option expires, the investor is obliged to sell their shares to the buyer of the call option at $192.50, which means they receive $19,250 ($192.50 x 100 shares), plus the $200 options premium.