Negosentro | Capital Gains vs. Investment Income: Differences Explained | Most people don’t understand the difference between capital gains and other investment income they generate. Officials differentiate between the two by focusing on where the profit comes from. Investors must understand this when they file their taxes or plan for their retirement.
The initial sum the person invests in an asset is the capital, and capital gains are the funds they bring in when selling the investment for a profit. Investment income, in contrast, is any money the person makes from dividends, interest payments, and profits made from an investment vehicle. However, other differences exist that a person must be aware of before taking advantage of an opportunity fund investment or another investment vehicle.
Understanding Capital Gains
When a capital asset increases in value, it is referred to as a capital gain. This increase in value may be with an investment the individual holds or in real estate they own. The value at the time of the sale is higher than the initial purchase price. However, a person does not realize this gain until they sell the investment for a profit.
A good example of this is when a person purchases a stock and later sells it for a profit. Imagine buying 100 shares of stock in a company. Each share costs $10 at the time of purchase. The capital expenditure is $1,000 or 100 x $10.
While the investor holds the stock, it doubles in value. The investor chooses to sell and makes $2,000 from the sale of the shares. The capital gain on this investment is $1,000, which is the selling price minus the purchase price.
How Does Investment Income Differ from Capital Gains?
Most individuals live on their employment income. However, they can make investment income through the financial markets and do so with little effort on their part. Certain investment income comes from capital gains. Any additional income made from the investments is referred to as dividends or earned interest.
When calculating the amount of return on investment income from dividends or earned interest, a person doesn’t factor in the initial capital expenditure or how much they paid for the asset. Think of the interest earned on a savings account. If a person makes interest by keeping their money in this account, the interest earned is referred to as investment income.
However, an investor must take other things into consideration when determining the differences between capital gains and investment income.
The Taxation Rate
Capital gains are taxed differently than investment income, and an investor must recognize this. The tax rate varies by the type of investment, the profit generated from the investment, and how long the person owned the investment before disposing of it.
When an investor holds an asset for less than one year, authorities classify the capital gains as short-term. The person would be taxed at the same rate their ordinary income is taxed for that given year. On the other hand, when the person holds the asset for longer than 12 months, any profit made from the sale would be deemed long-term capital gains.
Authorities only tax the net capital gains for the given tax year. To determine what the net capital gains are, the investor deducts any income lost on investments at the time of sale from the capital gains for the year. The typical investor pays less than 15 percent in taxes on capital gains.
Knowing the distinction between investment income and capital gains is essential. In addition, investors need to understand how each is taxed. This ensures they pay the correct tax amount and don’t run into trouble with authorities. Seek outside help if needed to ensure this does not happen.