How Will Your Investment Make Money?
When it is time to begin investing your money in something besides your retirement accounts, you will find there are myriad of options to choose from. Regardless of what type of investment you decide to make, a question many people have is how are they going to make money? Why is this particular investment the one to choose, and how is it going to provide returns?
You will earn interest income on any type of debt instrument as a type of compensation for giving the investor’s principal to the issuer or borrower. This income is paid by a number of investments, including:
- Fixed income securities, including bonds and CDs.
- Fixed annuities
- Demand deposit accounts, such as money market, savings and checking accounts.
- Mutual funds
- Seller-financed mortgages
No type of equity will pay interest. Each of the debt instruments mentioned above, pay a certain rate of interest that is typically fixed, but that can be variable based on the investment terms.
For demand deposit accounts, the rates will typically fluctuate based on changes in interest rates, and for fixed annuity contracts and CDs, the interest will likely remain constant until maturity is reached.
A dividend is a type of cash compensation given to equity investors. These represent [sociallocker id=”4032″] a part of the company’s total earnings that are passed to the shareholders, either on a quarterly or monthly basis.
Interest and dividend income are similar, as they are typically paid at a certain rate for a specified amount of time. However, dividends will only be paid on stocks or from a mutual fund that invests in stocks. But, not all stocks are going to pay dividends. In most cases, only established corporations will pay this, while smaller-cap enterprises will retain cash to continue growing.
Dividends will be paid for both preferred and common stocks, but the rate is typically higher on the preferred stocks. Dividends are also either ordinary, which will be taxed as an ordinary income, or as qualified, which is taxed as a long-term capital gain.
The yield of dividends may vary based on the type of security they are paid.
A capital gain represents the price appreciation of an investment or security from the time it was purchased. The gains can be short- or long-term based on if the instrument that was sold was held for a year or not. Both fixed and equity income securities can post gains. A fixed-income security has the ability to appreciate in regards to price on the secondary market and designed to mainly pay the current dividends or interest, while real estate and stocks offer most of the reward to investors as capital gains.
There are some investments that offer tax-advantaged income. For example, working interests in gas and oil generate revenue that is up to 15-percent tax-free thanks to the depletion allowance. Additionally, passive income from limited partnerships that invest in oil and gas or real estate can be written off as passive losses.
There are some investment options that offer more than one type of return. A common stock may offer capital gains and dividends. Additionally, fixed income securities can provide dividend income, interest income and capital gains. The total return is determined by adding the capital gains to the interest or dividend income and considering the tax savings seen.
The Bottom Line
Due to all the different type of investment options, there are just as many return possibilities. Some will pay income as dividends or as interest, while others are going to provide capital appreciation. There are some that even offer tax advantages, as well as capital gains. Each factor is what comprises the total picture of an investment’s total return.
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