Investment income refers to the money earned from investments such as stocks, bonds, mutual funds, and real estate. It typically comes in the form of interest, dividends, capital gains, or rent payments. With proper planning, investment income can serve as a secondary income stream or even replace earned income entirely.
This comprehensive guide will explain everything you need to know about investment income, including:
- What constitutes investment income
- The most common sources of investment income
- How investment income is taxed
- Strategies for generating more investment income
- Frequently asked questions
What is Considered Investment Income?
The IRS defines investment income as earnings derived from assets purchased with the intention of generating a future return. Common examples include:
- Interest – Money earned from keeping money in accounts such as savings, checking, money market, and CDs.
- Dividends – A share of profits paid out to stockholders.
- Capital Gains – Profits made from selling an asset for more than the purchase price.
- Royalties – Ongoing payments for work already done, like book publishing rights or oil extraction rights.
- Rents – Money earned from allowing others to use property you own.
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Gains from selling collectibles, investments in partnerships, and earnings from passive business activities may also qualify as investment income.
Most Common Sources of Investment Income
While any investment has the potential to spin off income, these are some of the most popular and accessible sources:
High-Yield Savings Accounts
Savings accounts offer guaranteed returns and help protect the value of your money against inflation. Rates are still below historical averages, but the most competitive accounts offer up to 4% APY or more. This steady income can serve as the base of an income-oriented portfolio.
Money Market Funds
Money market funds invest in short-term debt instruments and pay dividends that typically align with short-term interest rates. They offer modest income, but the asset value doesn’t fluctuate, making them a lower risk option.
CDs pay higher interest rates in exchange for locking up funds for a set period, usually 3 months to 5 years. It’s important to ladder CDs so that money is always coming due that can be reinvested at current rates.
Investment Grade Bonds
Bonds are debt instruments that pay regular interest. Investment-grade bonds, which are higher rated, offer modest yields but with relatively low risk of default. Mixing short, intermediate, and long-term bonds can provide consistent cash flow.
Some stocks make regular dividend payments to shareholders that can generate hundreds or even thousands in annual income per investor. Blue chips stocks with long dividend histories make ideal income stock picks.
Real estate investment trusts are companies that own and manage residential or commercial properties. Equity REITs tend to pay above-average dividends, offering a way to earn rental income without having to buy and manage property.
P2P platforms connect individual investors and individual borrowers. Investors can earn interest rates in excess of 10% by funding personal loans, though standards for borrower quality vary widely across platforms.
Passive Income Businesses
Starting an online business that earns money with minimal day-to-day management can be a great source of semi-passive income. However, don’t underestimate the initial effort required. It takes significant upfront work before the income starts rolling in.
How Investment Income is Taxed
One of the major advantages of investment income is preferential tax treatment compared to ordinary earned income. However, the details get complex quickly.
Personal interest income is taxed as ordinary income based on your federal tax bracket. Interest on municipal bonds is exempt from federal tax but may be subject to state and local taxes.
Short-Term Capital Gains
Profits from selling assets held for one year or less are taxed as ordinary income. The short-term capital gains rate aligns with federal income tax brackets.
Long-Term Capital Gains
Long-term capital gains on assets held over a year qualify for preferential rates. For 2023, the long-term capital gains brackets are:
- 0% for singles making up to $44,625 and married couples making up to $89,250
- 15% for singles making $44,626 to $492,300 and couples making $89,251 to $553,850
- 20% for higher-income taxpayers
Dividends paid on stock held longer than 60 days also qualify for the same long-term capital gains rates listed above. This results in a significant tax advantage.
Net Investment Income Tax
Taxpayers who meet income thresholds may also owe the 3.8% Net Investment Income Tax (NIIT) on the lesser of net investment income or the amount by which modified adjusted gross income (MAGI) exceeds the thresholds. For 2023, the NIIT thresholds are $200,000 for singles and $250,000 for married filing jointly.
So while investment income enjoys some tax perks, higher income investors may still face substantial tax bills in some cases. A tax-advantaged retirement account can provide shelter from taxes on investment earnings.
Strategies to Maximize Investment Income
Generating meaningful investment income takes concerted effort over long periods of time. Here are some tips to hit your goals faster:
- Live below your means and save aggressively to build up investable assets
- Consider moving to lower cost areas to free up more money to invest
- Invest early and consistently, letting compound growth work its magic
- Reinvest earnings during the accumulation phase instead of spending
- Diversify income sources across asset classes to reduce risk
- Hold quality stocks and bonds long term to qualify dividends and gains for lower tax rates
- Consider relocating to low or no income tax states in early retirement to keep more investment income
Ramping up investment income does require diligent saving, investing, and managing taxes. But the rewards can be well worth it.
Investment income has major advantages as a secondary income stream or even a replacement for earned income in retirement. While it takes diligent saving and investing over long periods to build up a sizable portfolio, the tax-advantaged treatment can make your money go much further.
Diversify your assets across accounts, asset classes, industries, and individual holdings while reinvesting all earnings during the accumulation years. Stick to quality investments, understand how taxes come into play, and keep costs low. Then with time and compound growth, you can eventually reach investment income that rivals or even surpasses earned income.
The journey isn’t quick or easy, but taking control of your finances and building investment income for the future is incredibly empowering. So use this guide to plan out an approach that aligns with your individual goals. The rewards of increased financial security and freedom of choice make it well worth the effort.
Frequently Asked Questions
What types of income are considered “investment income”?
The main types of investment income are interest, dividends, capital gains, royalties, and income from rental properties or businesses. Gains from selling other capital assets may also qualify.
What are some easy ways to earn investment income?
High-yield savings accounts, CDs, money market funds, investment-grade bonds, dividend stocks, REITS, and peer-to-peer lending are some more accessible options for earning investment income.
Is investment income taxed at a lower rate than earned income?
Sometimes. Long-term capital gains and qualified dividends enjoy lower federal tax rates. But other investment income is taxed as ordinary income. Higher income investors may also owe the Net Investment Income Tax.
Is investment income from retirement accounts taxed?
Not directly. But withdrawals are taxed as ordinary income. One exception – Roth IRAs allow tax-free growth and withdrawals in retirement.
Can I replace my salary entirely with investment income?
It is possible, especially if you build sizable dividend portfolios, rental property income, or other cash-flowing assets. But it takes substantial assets and planning over long time periods for most people.
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