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We’re often asked, “what are funds extracted from funds?” However, a better way of phrasing this question is to ask, “what is investment income?” Investment income is simply another way of describing funds (cash) that have been extracted from investment funds or assets.
If you’re wondering what investment income is, and how you can generate investment income, read on. In this article, we’ll take a deep dive into the concept of investment income, simplify it for beginner investors, and discuss the best income-generating investments.
Investment Income 101
First, it’s important to make clear that investment income is not synonymous with capital gains. However, capital gains fall under the umbrella of investment income. Understanding this distinction is critical for filing taxes as well as planning for your retirement.
For starters, capital gains are profits gleaned from investments that are sold for more than their original purchase price. The surplus-value of the investment is the “capital gain,” which is taxed by the IRS at an average of 15 percent.
Investment income, by contrast, describes any profit that originates from interest payments, capital gains, dividends, or any other kind of profits generated via investment vehicles. Although employment income is the most popular form of earnings for individuals, many investors generate additional income through gains in financial markets—this is classified as investment income.
A Closer Look
Investment income is independent of the initial capital invested. For instance, let’s imagine you have a Roth 401(k) retirement savings account worth $10,000 with a 5 percent annual interest rate. In this case, the savings account will generate an investment income of $500 ($10,000 x 0.05 = $500) after one calendar year of vesting.
Dividend-paying investments generate investment income that is also independent of one’s initial investment sum. For example, if Company XYZ pays a dividend of $3 per share for 200 shares that an investor buys, then the investment income generated is $600 ($3 x 200 = $600).
Now, let’s look at capital gains. By definition, an investor does not realize a capital gain until the investment is sold at a profit. To illustrate what a capital gain is, let’s take the example of Company XYZ, of which an investor purchases 200 shares at a price of $100 each.
In this case, the capital expenditure totals $20,000. If the value of a Company XYZ share increases to $200, the total investment will now be worth $40,000 which would amount to a $20,000 capital gain if the investor sells their shares at market price. Therefore, you can easily calculate capital gains by subtracting the initial capital expenditure from the total income of the investment sale ($40,000 – $20,000 = $20,000).
Investment Income: Things to Consider
Investment income, like employment or self-employment income, is taxable. However, the tax rate that your investment income is subject to depends on the type of investment made, the amount of profit that it generates, and how long it vests.
Short-term capital gains are those that are realized within one year or less, and they are taxed as regular income. If the asset is held for one year or longer, then it’s classified as long-term capital gains which bear different tax implications. The amount of taxable capital gains for a given tax year is the total capital gains in the last year subtracted by total capital losses (i.e., the income lost by selling an investment for less than what it was bought for).
Long-term capital gains are taxed at graduated levels, either at 0, 15, or 20 percent. Since short-term capital gains are taxed as ordinary income (which can scale as high as 37 percent), the tax code incentivizes investors to hold onto their investments for longer than one year, whether it’s a stock, bond, precious metal, or piece of real estate. Whether an investor pays 15 or 20 percent on their long-term capital gains depends on their individual income level.
Investors with a single tax filing status pay a zero-percent rate on their capital gains if their income is $39,375 or lower. Single investors with an income of $434,550 or higher pay a 20 percent rate on capital gains, whereas married joint-filing investors pay a 20 percent rate on capital gains if their joint income exceeds $488,850.
Special Exceptions and Rates
Funds extracted from certain asset classes are taxed at special rates that differ from regular short-term or long-term capital gains. For your convenience, we’ve listed them below:
- Collectibles (28%): Includes gains on jewelry, art, stamps, precious metals, and antiques independent of the investor’s income
- Net Investment Income Tax (3.8%): An additional tax on investment income levied on those whose modified adjusted gross income exceeds $250,000 (married joint-filing) or $200,000 (single), or $125,000 (married, separate filing).
- Owner-Occupied Real Estate Exemption: The first $250,000 of capital gains gleaned from the sale of a house are excluded from one’s taxable income.
Dividends as Investment Income
Another popular form of investment income is dividends, which is a distribution of reward from a share of a company’s net earnings. Dividends are paid to shareholders and are decided by the firm’s board of directors and subject to approval by their shareholders. They are paid either as cash payouts, stock shares, or even property.
Many popular ETFs and mutual funds offer dividends to shareholders, in addition to company’s that issue stock (such as Walmart and Unilever PLC). Often, dividends are issued every quarter and range between 5 and 16 cents per share owned by the investor. Therefore, an investor who owns 500 shares in an ETF may receive a quarterly cash payout of $50 if the fund has a dividend payout rate of 10 cents per share. This is an example of funds extracted from funds.
The Key to Positive Cash Flow
Funds extracted from funds are critical for establishing reliable positive cash flow and generating wealth from your long-term holdings. Whether your investment income is generated by capital gains, dividends, or interest payments, you must understand the wealth-building potential of investment income as well as the respective tax implications of each asset class.