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Written by
Bob Haegele
Bob Haegele is a contributing writer for Bankrate. Bob writes about topics related to investing and retirement.
Edited by
James Royal, Ph.D.
Bankrate principal writer and editor James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
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When it comes to making money in the markets, investors have two main ways: capital gains and investment income. A capital gain is when an investment rises to a higher price than an investor paid. In contrast, investment income consists of payments such as dividends and interest as well as realized capital gains. How these sources of income are taxed differs, too.
Here are other key similarities and differences between capital gains and investment income.
Capital gains refer to an increase in the value of an asset, such as a stock or a bond. If the investor sells that appreciated asset, it creates a realized capital gain, which is taxable. If the asset remains unsold, then the capital gain is unrealized and capital gains tax is deferred.
For example, suppose an investor buys 10 shares of stock in their favorite shipping company at $25 per share. Their total investment in that company is $250. The company has a good year, and the stock price rises to $30, meaning the investor now has an investment with a $300 market value.
In this example, the capital gain is $50. If the investor decides to sell the shares, they would realize the capital gain and owe tax. If they decide to hold on, their capital gain will not be taxed. Investors can hold on to their unrealized capital gains and avoid tax indefinitely.
Some investors hold appreciated stock for decades and never owe capital gains tax. And if you’re investing with a Roth IRA — one of the best retirement plans out there — then you can avoid capital gains completely, even when you withdraw money from the account in the future.
Whereas capital gains come from selling an investment at a higher price, investment income derives from a company’s earnings. When a company turns a profit, it may distribute some of its profit as dividends or it may pay interest on any outstanding bonds.
For example, going back to our $30 stock, the company may decide to distribute some of its profits to them because it no longer needs to invest them in the business. It then chooses to pay a certain amount of cash to every outstanding share.
Let’s assume the stock pays a quarterly dividend of $0.25 per share. So the annual dividend would be $1.00 per share. So each quarter the investor receives:
The total annual dividend is:
At a price of $30, the stock yields a dividend of 3.3 percent.
Realized capital gains are another form of investment income. If an investor sells a stock with a gain and realizes that gain, then it legally counts as investment income and becomes taxable.
The circumstances for taxing capital gains and other types of investment income differ.
Dividends may be taxed in a couple different ways, depending on whether they’re ordinary dividends or qualified dividends.
Qualified dividends are taxed at rates of zero, 15 and 20 percent, depending on the tax filer’s income.
And unlike unrealized capital gains – which do not create a tax liability – dividends are taxable for the tax year they’re received, if they’re in a taxable account. Dividends in tax-advantaged accounts such as an IRA or 401(k) do not create a tax liability in the year they’re received.
Realized capital gains are also treated in a couple different ways, depending on how long the asset was held and how much income the investor has.
Long-term capital gains tax rates are often lower than ordinary income tax rates. Capital gains are taxed at rates of zero, 15 and 20 percent, depending on the investor’s total taxable income. That compares to the highest ordinary tax rate of 37 percent for 2024.
The capital gains tax rates are highly advantageous. In fact, a married couple filing jointly has a 0 percent capital gains tax rate if their taxable income is up to $89,250 in 2024 . Moreover, skillful maneuvering can allow you to earn more than $100,000 and owe no taxes.
It’s worth noting that investors can also write off losses from their investments, and may offset their gains with any losses. The process – called tax-loss harvesting – can save investors significant money when it comes time to pay taxes. And many of the best robo-advisors, including Wealthfront and Betterment, offer tax-loss harvesting at no cost.
Interest income is generally taxed as ordinary income, meaning it’s subject to the same federal tax rate as your income. This applies to interest earned from bonds, savings accounts and certificates of deposit. However, interest from state-issued municipal bonds may be tax-exempt if issued in your home state.
Regardless of whether interest income is taxable or tax-exempt, it must be recorded on your tax return using Form 1099-INT. Interest generated on tax-deferred accounts like traditional IRAs or 401(k)s doesn’t require reporting until you withdraw the funds.
Finally, income from dividends, capital gains and other similar forms of income may face an additional surcharge of 3.8 percent, called the net investment income tax. The assessment of this surcharge depends on the investor’s income and filing status.
Generally, the main way to avoid taxes on your capital gains and dividend income is to own these assets in tax-advantaged accounts such as a 401(k) or an IRA, especially a Roth IRA. Of course, an investor can hold appreciated stock indefinitely and never pay any capital gains tax.
Capital gains and investment income are two ways that investors can make money on their investments, and they’re treated differently for tax purposes. So it can make sense for investors to understand which approach to making money works better for their financial needs.
Bob Haegele is a contributing writer for Bankrate. Bob writes about topics related to investing and retirement.
Bankrate principal writer and editor James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
