If you ask investors why they invest, you’ll probably get several different answers.
For instance, they may want to buy a house, build wealth, save for retirement, etc. No matter the personal goal, the bottom line is this: When you invest, you’re hoping to make some money!
The money that you make from your investments is what's known as investment income. Pretty straightforward, right? But different types of investments can generate different kinds of income.
Some of you may be thinking: “Hey, money is money – what’s the big deal?” Fair question.
First, it’s important to have a basic understanding of how investment income works because it can help you choose an investment strategy that best fits your needs and goals.
Second, you usually have to pay taxes on investment income, and the tax rate will depend on the type of investment income you bring home. We won’t get too much into the tax discussion in this article since we’ve covered the topic here.
Ahead, we’ll focus on helping you nail down the basics by providing an overview of three common types of investment income: interest, dividends and capital gains.
Even if you’re brand new to investing, we bet you’re already familiar with interest income, which is the money you can earn through certain types of bank accounts and investments. Let’s look at a few examples.
When you park money in a savings account, money market account or certificate of deposit (or “CD”), the bank doesn’t just hold onto your deposits for you – it can lend that money to others.
Since you’re essentially letting the bank borrow your money, the bank pays you interest for it in return. Now, even though these deposit accounts aren’t typically considered investment products, the IRS treats the interest earned from these accounts as investment income for tax purposes.
Keep in mind that interest rate payments may be fixed or variable depending on the specific type of account or investment you have.
You can also earn interest income through investments like bonds or money market mutual funds.
If you’re an avid Marcus reader, you know we can go on and on about these interest-bearing investments, but we have other types of investment income to get to. (Dividends and capital gains need some love, too!)
So check out “How to Invest in Bonds” and “What Are Money Market Mutual Funds” to learn more about how these investments work.
Good to know: Keep in mind that interest rate payments may be fixed or variable depending on the specific type of account or investment you have. This is an important detail to pay attention to when considering your interest-earning options.
When you buy stocks, you have an ownership stake in the company (or companies) you invest in. If the company makes a profit, they may distribute some of that money to their shareholders (that’s you!) in the form of dividends.
Here’s a basic example of how dividends work. You invest in Company XYZ and own 100 shares of its stocks. The company pays $5 per share in annual cash dividends. That means that you would earn $500 ($5 x 100 shares) in dividend income. Sometimes, you may have the option to reinvest cash dividends back into the company, allowing you to buy more shares.
Some companies may choose to pay dividends in the form of additional shares instead of cash – this is known as a stock dividend.
Now, you don’t have to invest directly in a company to receive dividends. If you invest in stocks through a stock mutual fund or stock ETF, these investments can also pay dividends.
Good to know: While dividends can be a nice source of income, they’re not guaranteed. The decision to distribute dividends is usually up to a company’s board of directors. The board can decide, for example, when and how much dividends will be paid to its stockholders.
Certain investments can generate more than one type of investment income. For example, stocks may generate dividends and capital gains. Nice!
Some new investors may not be familiar with capital gains, which are the profits that you make when you sell an asset such as a stock, bond or exchange-traded fund (ETF) for more than the original purchase price.
Capital gains, like other investment income, are taxable.
Capital gains are considered “realized” when you actually sell your investment (you can learn more about realized vs. unrealized gains here.)
Let’s take a look at stocks again. Stocks may generate dividends while you hold on to them in your portfolio. But when you sell those stocks down the road, the sale may result in a capital gain if you make a profit.
Capital gains, like other investment income, are taxable. The federal tax rate you pay on realized capital gains depends on how long you’ve held your investments.
Long-term gains (investments held for more than a year) are usually taxed at a lower rate than short-term gains (investments held for one year or less).
Good to know: Figuring out the potential taxes you may owe on your investment income can get complicated. It’s a good idea to consult a tax professional if you have any questions or concerns about your specific tax situation.
Since you’ll likely have to pay taxes on your investment income, it’s a good idea to keep track of what you’ve earned.
This is where your financial institution could help. Each year, firms may send you some of the following tax forms with information on your investment income.
This article is for informational purposes only and shall not constitute an offer, solicitation, or recommendation to buy or sell securities, or of an account type, securities transaction, or investment strategy. This article was prepared by and approved by Marcus by Goldman Sachs®, but is not a description of any of the products or services offered by and does not reflect the institutional opinions of The Goldman Sachs Group, Inc., Goldman Sachs Bank USA, Goldman Sachs & Co. LLC or any of their affiliates, subsidiaries or divisions. Goldman Sachs Bank USA and Goldman Sachs & Co. LLC are not providing any financial, economic, legal, accounting, tax or other recommendation in this article and it is not a substitute for individualized professional advice. Information and opinions expressed in this article are as of the date of this material only and subject to change without notice. Information contained in this article does not constitute the provision of investment advice by Goldman Sachs Bank USA, Goldman Sachs & Co. LLC are or any of their affiliates, none of which are a fiduciary with respect to any person or plan by reason of providing the material or content herein. Neither Goldman Sachs Bank USA, Goldman Sachs & Co. LLC nor any of their affiliates makes any representations or warranties, express or implied, as to the accuracy or completeness of the statements or any information contained in this document and any liability therefore is expressly disclaimed.
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