What Is Investment Income?
Generally, people invest with the hope of making money and achieving their long-term financial goals. If you leave all your money in a checking or savings account, at current interest rates you will earn almost nothing. If you are willing to buy other kinds of investments, such as stocks, bonds and real estate, over time you expect your investments to grow.
To keep up with your cost of living, which is expected to increase over time, you want your investments to produce income and to grow in value. It is this aspect (how investments grow in value) that sometimes confuses investors. In short, your investments make money through a combination of interest income, dividend income and by selling an investment for more than you paid for it.
A simple example of interest income involves money deposited into a basic savings account. If you deposit $10,000 at 2 percent interest and a year later your account value is $10,200, you earned interest income of $200. If you only want to spend the income, you can withdraw the $200 and leave the $10,000 in the savings account. Next year, if the bank continues to pay 2 percent on savings accounts, you will be able to withdraw another $200.
Another example of income is the dividend paid on certain stocks you may own. Stocks pay dividends when the board of directors of the company declares they have excess cash with which to pay their shareholders. Dividends are not guaranteed. Some companies will pay annual dividends that you can take in cash or use to buy more shares of stock. Other companies will reinvest all cash to grow and expand their operations to add future value to the shares you hold.
Stocks have characteristics to consider other than just potential dividend income. You may be able to sell stocks for more or less than what you paid for them, producing a gain or loss. Therefore, your investment income can consist of the dividend income you received plus or minus your gain or loss on sale.
Let’s say Sally purchased stock in company ABC for $10,000 in 2010 and sold the stock five years later for $12,500. The company paid dividends of $2,500 over the five years. Sally’s investment income from the stock is $5,000, which includes the $2,500 of dividend income plus the $2,500 gain on the sale.
Bonds earn interest and also produce capital gains or losses. If you sell a bond before it matures, the value at that time may be more or less than what you paid based upon current interest rates. If you hold the bond until maturity, you will get back the principal you paid for the bond and your total earnings will just be the interest payments you received over the life of the bond.
Bob and Jane have a money market account and own stocks and bonds that show a statement value of $100,000 at the beginning of 2015. The interest and dividends paid in cash into their investment account for 2015 amounted to $3,000. A couple stocks (or mutual fund shares) were sold during the year, one for a gain of $5,000 and one for a loss of $2,000. After considering market performance, the value of their account at the end of 2015 was $115,000. The account’s total value rose by $15,000 during the year. However, if you were looking solely at interest and dividends paid into the account, you would think the portfolio’s investment income was only $3,000.
Realize that the interest and dividends you receive in cash from your investments may be just a small portion of your overall investment income. You cannot judge the performance of your investments by only considering the cash received each year. For instance, you may have sold investments during the year for more or less than what you paid for them, which is called a realized gain or loss. Additionally, the value of investments you hold may have increased or decreased in value, producing an unrealized gain or loss. Realized or unrealized gains and losses are important considerations when looking at your portfolio’s investment income as a whole.
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