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Investment Income vs. Capital Gains: Which Is Better?

Quentin Xavier Raitis an actuary working in London with experience in insurance, pensions, and investments

Read on to learn the difference between investment income and capital gains.

Read on to learn the difference between investment income and capital gains.

How Investment Returns Are Made

The reason we invest money is to end up with more money than we started with—to make a return on our investments. Broadly there are two ways of doing that:

  • getting an income from the investment, or
  • making a capital gain.

To understand the difference between investment income and capital gains, it helps to understand how investment works.

How Investment Works: The Big Picture

When we invest, we are giving our money to someone else (usually a company) to use for something productive. They then make money from whatever they are doing. And then pay us back.

This might be

  • paying our money back with interest (if we gave them a loan or bought a bond) or
  • paying us a share of the profits as a dividend (if we bought a share in the business), or
  • paying rent on commercial property.

The money invested is "capital," and the money paid out by the company as interest or dividends is our "income."

At a most basic level, these are the only options for how your investments pay out.

Here is a specific example of how stocks and shares investments make money.

Investing in Different Asset Classes

Different asset classes (such as stocks, bonds, or property) have a different mix of income vs. capital gains. Find out more about investment classes with some of these articles:

What Is Capital Gain? How Does It Compare to Income?

Income is easy to understand—it's the money we are paid by our investments (although you often have the option to reinvest that money rather than taking it as cash now). But what is capital gain?

Remember, capital here is the money we put into the investment. With some investments (like a savings account), you can just withdraw the capital, and it will be worth the same as when you put it in. But for other investments like bonds or stocks, or shares, you typically have to sell your investment to get the money back. That means that the price you get might be more or less than what you originally put in. If it's more, that is a capital gain (and if it's less, it's a capital loss).

To put it even more bluntly: Capital gains aren't really yours until you sell. You may have an asset that is worth more on paper, but the only way you can cash in is to sell at the market price, assuming that there is anyone willing to buy. Fortunately for "high quality" stocks or bonds, there is usually a pretty efficient market, so you have a fair idea of the price you will get. But if you invest in hard-to-value things like property or artworks, you may have difficulty knowing how much you will get until the sale is over.

You may have an asset that is worth more on paper, but the only way you can cash in is to sell at the market price.

You may have an asset that is worth more on paper, but the only way you can cash in is to sell at the market price.

What's the Difference Between Income and Capital Gains?

The big difference is that the income is paid out by the company you have invested in, as savings interest, bond interest payments, or as a dividend. But capital gains happen because the market price for investment has gone up. In other words, it is based on the opinions of other investors.

In theory, if markets work properly, then the market price of the investment should be equal to the risk-adjusted present value of all the future possible income from the investment. So, again, in theory, income and capital gains should just be two sides of the coin—just different ways of getting you a return on your investment.

But in practice, market prices vary quite a lot. This means that generally, income has a more stable and predictable cash flow compared to depending only on capital gains.

On the other hand, if you are reinvesting your money rather than using the cash flow immediately, it may be simpler and more tax efficient to receive capital gain rather than income.

Income has a more stable and predictable cash flow compared to capital gains.

Income has a more stable and predictable cash flow compared to capital gains.

Which Is Better: Capital Gains or Income?

There is no simple answer to that question. It depends on your situation, on what you want and needs from your investments.

What Is Your Risk Threshold?

If you are going to take your investment returns to live on rather than reinvesting them, then you are probably better off with investments that have relatively high stable incomes, like corporate or government bonds or dividend-paying stocks and shares or property. This is because you will have more certainty over your actual cash flow—the money actually paid to you.

On the other hand, if you are only interested in long-term capital appreciation and are happy taking risks, you may be better off investing in assets that may give you a high capital gain, such as non-dividend paying stocks and shares or commodities such as gold.

Other Factors Affect Returns

However, there are a lot of other factors that will affect your returns from these different asset classes, so you can't just think about whether you prefer income or capital gains. For example, don't forget that most of the time higher return investments come with higher risk; this isn't necessarily a problem so long as you understand the risks you are taking and are comfortable with them. This is something you may wish to take personal financial advice about, as everyone's circumstances will be different.

Income and capital gains are also taxed differently. In recent years many countries have made capital gains less taxed than income, which is one reason many investors now prefer capital gains. However, this is a complex area, and you should check out thoroughly the rules that apply wherever you are.

Consider Your Needs

Income and capital gains are both ways of receiving a return on your investments. Assets that focus on income are generally more stable, and assets the focus on capital gains are often more exciting. But the important point is to find investments that meet your needs, whether that is money now or growth for the future, and then get as good a return on your investments as you can.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

Comments

Elaine Brumbaugh on January 24, 2018:

Good to read!

Quentin Xavier Rait (author) from UK on August 28, 2014:

Quite right, Wilderness. Needs change. Which is one reason we should all keep our investments under review to check they still meet our needs. There is not one "right answer" to choosing where to invest!

Dan Harmon from Boise, Idaho on August 28, 2014:

Absolutely correct that investments must meet your needs, and I would add that those needs will change over time. The 30 year old investing in a retirement account has very different needs than a retiree depending on those investments for living expenses.

Taleb AlDris on April 22, 2013:

I agree with you.

Quentin Xavier Rait (author) from UK on April 22, 2013:

Thanks Taleb80! When investing it's tempting to think you can find a magic pot of gold at the end of a rainbow. It's much better to set sensible objectives and be happy when you meet them!

Taleb AlDris on April 22, 2013:

Very wise sentence "the important point is to find investments that meet your needs". Thanks for sharing this informative hub.

I Voted Useful.