Investing 101: Understanding types of investment income

Understanding the variety of investment income types can increase your earning potential, without increasing your time and effort. But it’s where you choose to invest that holds the key to transforming your financial gains and optimizing your tax situation.

Investments can earn higher returns than savings accounts, but of course, there's a catch: Those higher returns for investments aren't guaranteed. While saving generally involves very little risk, investing can come with a lot of risk. Investing over time and in a variety of different types of investments can help to reduce the risk. When you choose investments, you should consider your own risk capacity and risk tolerance.

Another important consideration should be the types of investments you choose. Stocks, bonds, mutual funds and other types of investments have different risk profiles and are taxed at different rates. So, the investments you choose and how long you own them can affect how much you'll earn and how much income tax you'll owe.

What is investment income?

Investment income is money you earn from buying, owning and selling investments.

There are three basic types of investment income that you should know about:

• Capital gains
• Dividends
• Interest

Understanding these types of investment income may help you choose which investments are a good fit for you.

What are investment capital gains?

Capital gains are a type of investment income that you may earn when you sell an investment that has increased in value since you purchased it. Stocks and stock mutual funds are two examples of investments that may produce capital gains, which are considered income for federal tax purposes. How much you pay in taxes will depend on how long you've held the investment:

• Short-term gains result from investments you've owned for up to one year and are generally taxed at the same rate as your ordinary income.
• Long-term gains result from investments you've held longer than one year and are usually taxed at a lower rate.

Before you sell an investment, any capital gain (or loss) that you have is said to be "on paper" because the investment's value may still change. When you sell the investment, your gain (or loss) is assured and said to be "realized."

If you buy individual stocks, you control when you realize your capital gains (or losses). If you invest in mutual funds, your funds will accumulate the capital gains, if any, and distribute them to you, usually at the end of each year.

What are investment dividends?

Profitable corporations sometimes choose to distribute some or all of their profits to their shareholders in the form of a dividend rather than reinvest those funds in their operations. If you're an investor in that corporation, you may receive cash or additional shares when a dividend is distributed.
For income tax purposes, dividends may be taxed at different rates depending on how they’re classified by the IRS. Your tax rate for dividend income may also depend on your income bracket and filing status.

What is investment interest?

Interest is a type of income that you may earn from investments that involve debt, such as government or corporate bonds. When you invest in debt instruments, you're in the position of the lender, not the borrower. That means you earn interest rather than pay it. How much interest bond issuers pay their investors usually depends on the overall level of market rates and the perceived risk of the bonds, among other factors.

Corporate bonds tend to be riskier and pay higher rates than government bonds, but they're generally fully taxable. Government bonds may be exempt from federal, state or local income tax.

You can buy bonds directly from issuers or on secondary markets where bonds are traded after they're issued or through bond mutual funds.

Other Types of Investment Income

Stocks, bonds and mutual funds aren't the only types of investments that can generate investment income. In fact, there are other options you may also want to consider. Here are some examples:

• Real estate, which may earn rental income.
• Intellectual property, which may earn royalties.
• Annuities, which are a type of insurance.
• Business partnerships, which may distribute profits.
• Commodities and futures, which may generate gains from changes in market prices.

Investing can be complicated. That's why many people choose to invest with a professional advisor or through an automated investment service. Whether you choose to get help or become a DIY investor, taking the first steps can set you on a path toward a lifetime of investment success.