What Is Investment Income?
Investment income is money you earn from the increased value of your investments. The income you earn may include the dividends you’re paid on your stocks, capital gains you realize from the sale of your investment properties, interest you earn on your savings or money market account balances, or other profits you make through investment vehicles. While most people live off the income they earn from working, investment income can be another stream of earnings to help with monthly expenses.
If you’re looking to increase your overall wealth or current income, investment income can be beneficial. The interest you earn on your investments that is more than the initial amount you invested is the profit you make, but once you cash in on it, you’ll owe taxes. Although you’re required to pay taxes on your profit, investment income may still make you feel more financially secure if you earn it in addition to your regular paycheck.
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Types of Investment Income
You can earn income passively, actively, or through a combination of both. When your investments earn profit, it’s provided to you in the form of interest or dividends.
Passive income is generally described as profit you make from investments that don’t require a lot of effort or transactions on your part. Examples of passive income include buying and selling real estate or earning interest on a savings account balance. Passive income is a beneficial way to earn investment income because it doesn’t require a lot of time or active involvement.
You earn active income when you obtain wages from working or when you participate in business activities that earn profit. For example, if you work full-time for a company, the paycheck you receive every two weeks for doing your job is your active income.
This type of income is beneficial because it’s generally steady and predictable. Active income allows you to plan your monthly budget. Since you work for active income and don’t rely on outside factors to determine your profit, it isn’t associated with much risk.
Savings or money market accounts can earn you investment income in the form of interest. When you leave balances in these accounts, financial institutions issue interest payments, which are usually a small percentage of the balance in the account. Therefore, the higher the balance in the account and the higher the interest rate the bank offers, the more investment income you can earn in the form of interest.
There are a few different ways to receive dividends as your investment income. If you own exchange-traded funds (ETFs) or stock managed by mutual fund companies, you can earn dividends if the value of these funds increases by more than your investment.
If you own shares of companies, you may also earn dividends. When investors own shares in a company, the company must distribute part of its earnings as dividends to these shareholders. The amount of dividends owed to the investor depends on how many shares an investor owns and how much profit the company earned. While cash dividends are the most common form, shareholders may also receive these dividends as additional shares of stock or other property.
Investment Income Taxes
Investment income is subject to federal taxes but the tax rate you must pay varies, based on the type of investment you profited from and your situation. Generally, you will face one of two different types of taxes once you withdraw your money, depending on the type of investment income you earned.
Net Investment Income Tax
If you make significant investment income, you may be required to pay a net investment income tax. Net investment income is the income you receive from investments, such as stocks, bonds, loans, or mutual funds. It is subject to the net investment income tax at a rate of 3.8% if your modified adjusted gross income (MAGI) and the net investment income you earned is above a certain threshold.
As an unmarried tax filer, if your MAGI and investment income totals $200,000 or more, you must pay the net investment income tax. As a married joint tax filer, you must pay this tax if your MAGI and investment income totals $250,000 or more.
A capital gain occurs when you sell an asset for more than you purchased it for. E.g., you bought a house three years ago for $100,000 and you just sold it for $150,000, so you earned $50,000 in capital gains. In this example, you would owe capital gains tax on $50,000 since that’s the profit you made. Since you owned your real estate investment for more than one year, you must pay the long-term capital gains tax, which is usually less than the short-term tax.
The short-term capital gains tax applies to investments you owned for one year or less. The rate for this tax is generally higher than the long-term capital gains tax and is usually equal to ordinary income tax rates.
Living Off of Investment Income
Investment income is helpful because it can assist you in paying for monthly expenses, such as utility bills or medical emergencies. If you don’t want to solely rely on your paycheck each month, investment income can be another way to earn money. However, there are advantages and disadvantages to attempting to live off of investment income.
If you place your money in savings accounts or money markets, you are generally investing in low-risk vehicles that will garner a return. While the monthly investment income you earn on these accounts may be low, it’s reliable and predictable. Making long-term investments that eventually result in receiving investment income will not allow you to experience a pay-off right away, but can contribute to a large return down the road, or to your retirement fund.
Less predictable investment vehicles, such as stocks, aren’t as reliable for steady income. When it comes to investments, it’s generally said that the greater the risk, the greater the reward. However, living off of investment income may lead to risky financial moves that don’t pay off in the end.
If you use the investment income you earn for monthly expenses, you’re pulling it away from other potential investment opportunities. The ability to reinvest your dividend or interest payments into your investment vehicle(s) may lead to higher long-term earnings.
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This post was updated November 26, 2019. It was originally published November 26, 2019.