Capital Gains vs. Investment Income: A Comprehensive Comparison

Step-by-Step: Differentiating Capital Gains and Investment Income

By investing in the market, we make money in two different ways: capital gain and investment income. But what is capital gain, and what is investment income? There are many differences between capital gain and investment income. Let's find out their differences and see how these two money-making strategies are taxed differently.

Key Highlights

  • Capital gain and investment income are two different ways of earning money from investments. 

  • Capital gains rise from selling and investing at a higher price than the original price, while investment income includes dividends and interests. 

  • Capital gains are classified into short-term and long-term capital gains based on the asset's holding period.

  • Investment income is divided into dividend income and interest income.

How Do Capital Gains and Investment Income Differ?

Dive into the world of capital gains and investment income. Understand the variances and implications to maximize your financial success.

What Are Capital Gains?

Capital gain is a profit that you make on your investment when you sell your investment for a higher price than the original purchase price. When the value of an asset like stocks, bonds, real estate or precious metals increases over time and when you sell the appreciated asset for a higher price, it is a capital gain. However, you must also note that capital gains are only realised when you sell your asset. Until then, they remain unrealised and are not subject to taxation.

Capital gains are further divided into two types: Short-Term Capital Gain and Long-Term Capital Gain.

  • Short-Term Capital Gain: When you hold your asset for one year or less before selling, they are termed as short-term capital gains. The short-term capital gains are taxed at an ordinary income tax rate of an investor that ranges from 10% to 31%, depending on the text bracket.

  • Long-Term Capital Gains: These are the assets that are held for more than a year, and when they are sold, they are classified as long-term capital gains. They are subject to a preferential tax rate, which is typically lower than the ordinary income tax rate. It is generally between 0% and 20%, depending on the taxable income of the investor.

Suggested Articles: The Best Short-Term Investment Options for Higher Returns

What Is an Investment Income?

Investment simply refers to earning from assets and investments. This means that investment income includes different forms of earnings that come from investment, such as dividend interest in realised capital gain. Unlike capital gains that come from asset appreciation, investment income comes from the earnings of a company or interest payments on bonds.

Investment income is divided into dividend income and interest income.

  • Dividend Income: Dividends are those payments made by companies to their shareholders when they distribute profits among them. They can be either ordinary or qualified, depending on the specific criteria outlined by the IRS. Ordinary DP dances are text at the ordinary income tax rate of an investor, while qualified dividends are subject to preferential tax rates.

  • Interest Income: Interest income is earned from investments in interest-bearing assets like bonds, savings accounts, certificates of deposit, etc. Interest income is generally defined as ordinary income and is also subject to the marginal tax rate of an investor.

Things to Consider Before Paying Taxes

Learn about the important factors to consider before paying taxes.

Capital Gain Taxes

Capital gain taxes are an important aspect of investment income taxation, which are subject to different rules and traits depending on the duration of the assets held and the income level of the investor.

  • Short-Term Versus Long-Term Capital Gains

When you sell the investment within one year or less, it results in short-term capital gain and is taxed at an ordinary income rate. Here, you are subject to the same tax bracket as another form of income that ranges from 10% to 37%.

Conversely, when you sell an investment that has been held for more than a year, it results in long-term capital gain. Hence, it is subject to different long-term capital gain tax rates. They are typically lower than the ordinary income tax rate, which is set at 0%, 15%, and 20%, subjected to the total taxable income of the investor.

  • Advantage

The long-term capital gain tax rate offers a significant advantage over the short-term rate. This is why investors are increasing their investment by adding buy-and-hold strategies to promote long-term capital investment.

  • Tax Loss Harvesting

An investor can offset their capital gain with capital losses, which reduces their overall tax liability. It is called tax loss harvesting, which involves selling investments at a loss to balance the gains in the portfolio.

Investment Income Taxes

Investment income is again divided into dividend and interest income, which also significantly impact the investor's text return.

  • Dividend Income

Ordinary Dividend Vs Qualified Dividends: Ordinary dividends are taxed at standard income tax rates, which can range from 10% to 37%, depending on the income level of an investor.

Qualified dividends, on the other hand, receive more favourable tax treatment where the takes rate is 0%, 15%, or 20%, depending on the income tax payer. However, to qualify for preferential treatment, the investor must hold their investment for a specific period of more than 60 days. 

  • Interest Income

Interest income earned from bond saving accounts or certificates of deposit is generally taxed as ordinary income. It is subject to the same federal tax rate as other forms of income. However, interest from state-issued municipal bonds is exempted from taxes if they are issued in the state of the investors.

  • Tax-Free Option

One effective way to minimise taxes on investment income is to hold these assets in tax advantage accounts like 401ks or IRS. These assets grow tax-free, which provides major tax benefits over the long run.

Final Words

Capital gain vs investment income may sound similar, but there are major differences. Capital gains are the financial gains that are realised from selling and investing for a higher price than the original purchase price. On the other hand, investment income is earned from assets such as dividends and interest. Capital gains in investment incomes are taxed differently. However, by utilising a text loss harvesting strategy, you can offset your capital gains and reduce your overall liability.

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11 Apr, 2024

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