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 gainscollected as a result of the sale of a security or other assets, and other profits made through aninvestment vehicleof 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.
Key Takeaways
- 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.
Capital Gains
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).
Investment Income
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.
Special Considerations
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%.
FAQs
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.
What is the difference between net investment income and capital gains? ›
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.
What is the difference between capital gains and income from other sources? ›
Income from Capital Gains: Capital gains arise when there is a profit or loss from the sale of capital assets like property, stocks, mutual funds, or other investments. Income from Other Sources: This head encompasses all residual income sources that do not fall under the other four heads.
What is the difference between capital and investment? ›
Investments are made with the expectation of generating long-term growth, while capital is used to fund ongoing business operations. Additionally, investments can come in various forms, while capital is typically represented by cash or other assets used to generate income.
What is the difference between income and investment income? ›
Key Points. Earned income is the money you make in salary, wages, commissions, or tips. Investment income is money you make by selling something for more than you paid for it. Passive income is money you make from something you own, without selling it.
Are capital gains taxed differently than income? ›
Capital gains and losses are classified as long term if the asset was held for more than one year, and short term if held for a year or less. Short-term capital gains are taxed as ordinary income at rates up to 37 percent; long-term gains are taxed at lower rates, up to 20 percent.
What is the difference between income and gain? ›
Gain can be regarded as profit made in exchange for something. The income from sale of product or services is treated as the revenue of the business. The increase in the value of property or asset can be considered as the gain of a business.
What is the difference between income and capital? ›
Capital includes all assets (cash, investments, buildings, machinery etc.) that have value. Income is money that is earned. It can be earned by capital (interest on a bank account, profit from a business, dividends from stock), or by labour (payment for work done).
How are earned income and capital gains different? ›
If you're one of the millions wondering how capital gains work versus income tax, you're in the right place. In a nutshell, capital gains taxes are applied to the profit made from selling a capital asset, such as stocks or real estate. Ordinary income taxes are applied to certain income and short-term capital gains.
What is the difference between capital and revenue investment? ›
Capital transactions involve the purchase or sale of long-term assets and are incurred occasionally. Revenue transactions, meanwhile, are more frequent and involve cash inflows and outflows that are incurred during the regular course of business.
Is it business income or capital gain? The distinction is important because business income (or loss) gets included in income at 100%, whereas a capital gain (or loss) is only included in income at 50%.
What is capital gains income? ›
Capital gains are the profits you get when you sell an asset. Capital gains can be subject to either short-term tax rates or long-term tax rates, depending on how long you owned the asset. By Tina Orem. Tina Orem. Assistant Assigning Editor | Taxes, small business, Social Security and estate planning, home services.
What qualifies as investment income? ›
Investment income is the money you make from your investments, including common accounts, such as interest-earning savings accounts and brokerage accounts. While investment income is a great way to build wealth, keep in mind that some investments can complicate your taxes.
What is the capital gains tax on investment income? ›
According to the IRS, the tax rate on most long-term capital gains is no higher than 15% for most people. And for some, it's 0%. For the highest earners in the 37% income tax bracket, waiting to sell until they've held investments at least one year could cut their capital gains tax rate to 20%.
What is investment income on capital? ›
When you buy an investment and then sell it you may have (hopefully!) made a profit. That's known as a capital gain, and you may have to pay Capital Gains Tax (CGT) on it – but only if the investment is held outside a tax-efficient account such as an ISA or Self-Invested Personal Pension (SIPP).
How do I avoid capital gains tax? ›
Use tax-advantaged accounts
Retirement accounts such as 401(k) plans, and individual retirement accounts offer tax-deferred investment. You don't pay income or capital gains taxes at all on the assets in the account. You'll just pay income taxes when you withdraw money from the account.
