What Is Investment Income?

Whatever your financial goals may be – whether it’s to build wealth, save for retirement, or something else – many people invest hoping to earn a return. The money you make from your investments is what's known as investment income. And different types of investments can generate different kinds of income.  

It’s important for every investor 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.

Also, 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 go over the three common types of investment income:

• Interest
• Dividends
• Capital gains

Interest income

Even if you’re relatively new to investing, you’re probably already familiar with interest income, which is the money you can earn through certain types of bank deposit 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, the bank doesn’t just hold on to 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. 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.

You can also earn interest income through investments like bonds or money market mutual funds.

Check out “How to Invest in Bonds” and “What Are Money Market Mutual Funds” to read 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. 

Dividends 

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 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. 

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.

Capital gains are considered “realized” when you actually sell your investment (you can read more about realized vs. unrealized gains here.)

Let’s use stocks as an example 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, in part, 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). See IRS Topic #409 for more details.

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. 

Keeping track of your investment income

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.  

• Form 1099-INT for interest income
• Form 1099-DIV for dividends and other distributions (including capital-gains distribution)
• Form 1099-B for proceeds from certain investment sales and transactions