Investment returns come in several forms. The terminology of returns can be confusing to new and seasoned investors alike. Understanding the different types of investment returns is essential for investors to evaluate investment performance and make informed investment decisions.
Additionally, understanding investment returns helps investors with tax management. Here is a primer on investment returns, which may be beneficial for investors at all levels.
Many investments generate interest income. Cash generates interest, as do CDs and bonds. Interest income is generally expressed as a percentage of an investment’s value over some time. For the sake of comparing alternatives and having a common frame of reference, interest rates are most often expressed as annual rates. This is typically true even when an investment is not designed to be held for a year, such as a three-month CD.
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Interest is a fixed income. For example, a bond that pays 4 percent interest and has 10 years to maturity will pay that interest for the entirety of that period. Interest generating investments are often referred to as fixed investments. Note that there are some exceptions, where these investments can pay variable rates in some specific situations.
Interest income is generally taxable to the investor as ordinary income at the time it is received. In that sense, it is much like income such as wages; you are also taxed on wage income at the time it is received.
If an interest-bearing investment is held in a tax-deferred account, then the tax is deferred until the funds are withdrawn; there is no tax due upon receipt.
Corporations return excess profits to investors in the form of dividends. Not all corporations pay dividends.
Some pay them regularly; others never pay them.
The most common form of dividend is a cash dividend, where the payment of the dividend to the shareholders in the form of cash. Investors may receive preferential tax treatment for dividends the IRS considers qualified dividends.
There are specific rules governing what makes a dividend qualifying, including how long the investor has owned the investment. For investors who are holding stocks that pay regular dividends, the dividends will generally be qualified dividends for tax purposes.
The next most common form of dividend is a stock dividend. A company may choose to reward investors with additional stock instead of cash. Stock dividends are not regular like cash dividends generally are; dividends are not taxable to the investor when received. Stock dividends dilute the value of the share price, meaning an investor will typically own more shares but not have more value immediately after the dividend is paid.
Capital Gains and Capital Appreciation
Capital gains and capital appreciation are often taken to be the same thing. They’re not.
Capital appreciation is the increase in the value of an asset. It doesn’t matter if the asset is a stock, a bond, or a house. If it increases in value, that is appreciation.
A capital gain occurs when you sell an appreciated asset. Capital gain is when you realize your appreciation. Let’s look at an example to make sure it is clear.
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Let’s say you purchased 100 shares of XYZ Company stock at $50 per share. We’re going to ignore transaction costs for our example.
Let’s say that now, two years after you bought your XYZ shares, they’re worth $70 per share. Your initial investment was $5,000; your investment is now worth $7,000. You have $2,000 in capital appreciation.
Now let’s say you sell your XYZ shares at $70 per share. We’ll continue to ignore transaction costs. Your $2,000 of appreciation becomes capital gain.
Capital appreciation is not taxable; you would have to sell your appreciated asset to make that increase in value taxable. That’s where capital gain comes in. You sell an appreciated asset, your appreciation becomes gain, and gain is taxable, generally speaking.
For tax purposes, we differentiate between assets held a year or less, which is the short term for capital gains purposes; and assets held for over a year, which is long term for capital gains purposes. Long-term capital gains rates are lower than those for the short term, which are taxed as ordinary income. Losses are also a factor; capital losses are netted from gains for tax purposes.
A loss can offset a gain, saving you some tax dollars.
Mutual funds often pay capital gains distributions annually. These are the investor’s share of gains for assets sold by the fund during the year. In this case, an investor may have to consider both capital gains and capital appreciation from the same asset. Note that investors typically reinvest capital gains distributions and would see their return in the form of additional shares.
The Bottom Line
Investors are concerned — naturally — with how investments perform, both absolutely and about their other investments or other options. In this case, their interest is in total return.
The total return is the sum of the various types of returns an investment generates during a period.
Typically we look at periods of a year or multiple years, allowing us to express the return as an annual rate of return for comparison purposes.
If an investment generates interest or a dividend, you add that to any gain or appreciation you have to calculate the total return. Often, when investment incomes are irregular, it may help to use a return that an investment firm calculates who has taken the ins and outs into consideration.
The total return from an investment is a good number for comparing alternatives — at least in terms of return. Taxes are naturally a factor, as you get to spend only what you keep. Two investments may have the same total return, but one has a better after-tax total return, allowing the investor to keep more of what they made.
Understanding the forms of return, and their taxation, helps investors evaluate their investments and make informed investment decisions. And that’s how we get better financially.