Capital Gains vs. Investment income: A Brief Overview
The big difference between regular profits and other forms of investment income is where the profit is generated from. Understanding the difference is fundamental in terms of what one needs to do with the money they earn. Regular profits, or what we commonly refer to as passive investments, come from the capital appreciation of a property or portfolio. The value of the entity (i.e. stock) increases over time, allowing you to realize a profit.
Conversely, investment income is generated by the increase in the net worth of an entity (i.e. stock). In this type of situation, the increase in value is directly proportional to the amount of money invested. Thus, if someone invests twice the amount of money, he will end up with twice the profit.
To break it down simply, there are two different types of profits. The first type of profit is referred to as the realized profit margin. The amount of profit realized per transaction is dependent on the amount of trading leveraged (i.e. traded for a specific amount of money). Therefore, if you have a large trading margin, your profit margin will be greater than the total return you would receive if you sold all of your shares and replaced them with new investments. Because trading leverage is a key part of becoming a successful investor, you must always consider the total return you can expect for each trade, not just the return on your single trade.
The second type of profit, capital gains, is not reliant on the size of your investment portfolio, but rather, on the current tax rate. Simply put, there is a certain amount of profit that is subject to taxes, regardless of what the tax rate is. As an example, let us assume that you are investing ten thousand dollars in your retirement account. Over the course of three years, you would have earned approximately eleven thousand dollars. If you were to take out a twenty thousand dollar second mortgage on your retirement account, you would essentially be limiting your retirement account to ten thousand dollars in value.
Your tax rate will impact how much you earn from your investment portfolio, which in turn will impact your investment income. In general, the larger your investment size, the higher your potential for capital gain and, therefore, higher your annual income. However, it is important to remember that even small increases in your investments will have a significant impact on your annual income. This is due primarily to the inflation process that occurs as the stock market grows over time.
When comparing different investments, you must also compare the amount of risk associated with each investment. For example, the risk of holding stock in a mutual fund versus the potential profit gained from an investment in the stock market are very similar. However, the stock market has a much higher fluctuation than the mutual fund. Because of this, the potential profit from the mutual funds is likely to be less than the profit obtained from the investment in the stock market.
It is also important to compare different types of investment such as fixed income and variable income. With a fixed income investment, you receive your initial investment in the form of a check. As long as the check is active, your investment grows automatically without having to sell or borrow your money. This type of investment is much safer than other forms, and has the potential for much higher returns. On the other hand, the volatility of variable rate investments can lead to high risk, especially if the value of the portfolio fluctuates significantly on a regular basis.
One important area that many investors overlook is their local area investment rules. Some areas have a very low or no capital gains rate, while others have a very high rate. Generally speaking, you will receive a greater tax return by staying in your home state and paying your taxes at home. However, some states such as Nevada have very high capital gains rates. If you are considering an investment property in Las Vegas, talk with a professional investment attorney who can provide you with solid advice regarding whether or not your investment would be beneficial in your home state.
