In this article, you'll learn about the different types of investment income you can earn from various investments.
Not all investments generate income but we look to fill about 80% of our portfolio with income-producing money machines.
And guess what? We collect lots of different types of investment income.
The 7 Types of Investment Income
Not all investments produce the same type of income, and some investments produce no income.
As an investor, your focus should be heavily weighted toward investments that currently produce income.
Investments that do not produce income only rely on the value of appreciation. On the other hand, investments that produce income can return all of your original investment funds back to you in the form of earnings.
And the good news is you still own the investment!
Here's a look and a brief description of different types of investment income you may come across as you evaluate investments…
When investing in stock, it is important to make sure the stock regularly pays dividends to its stockholders. A dividend is a payment, often quarterly, from the company of whose stock you own.
Usually, this dividend payment is a portion of the after-tax profits made by the company. However, it can also represent a payment from reserves or the sale of assets (discussed in the Special Dividends section).
When you evaluate a stock for purchase, it is important to understand where the funds to pay the dividend come from.
You want stocks whose dividends are paid from the profits of the business. Stay away from cash reserves or the special sale of assets. This is because cash reserves and assets can run out (meaning no more dividend payments). Payments from net earnings continue as long as the company stays profitable.
As mentioned in the dividends section above, some dividends are not paid from earnings but rather from excess cash balances or when an asset is sold and the funds are not used to purchase new assets or equipment.
These are called Special Dividends because they do not occur regularly, such as quarterly, but are usually one-time events
It is not uncommon for a special dividend to be a higher payment than normal quarterly dividends.
If you are aware of a special dividend distribution likely to come up soon for a stock, it may be a good clue to purchase it now. However, make sure that, on top of special dividends, the stock also makes regular dividend payments from company profits.
When money is invested as a type of loan, you earn interest on those funds.
This is how savings accounts and certificates of deposits work in banks. However, the interest payments paid by banks are typically the lowest possible interest rate. This is because these funds are considered the safest possible investments. Especially with the FDIC guarantee of up to $250,000 per depositor and bank.
However, better interest rates can be acquired by purchasing corporate bonds or our fave, baby bonds, instead of stocks. This is because bonds are loans guaranteed by the borrowing company. This is riskier than loans to a government-guaranteed deposit.
Bonds are also safer than stocks because if the company was ever liquidated, the bonds must be paid back completely before paying anything back to stockholders (all other debts must be satisfied as well before distributing final proceeds to stockholders).
Whenever an investment is sold, any profits on the investment (sales price less the original investment cost) are considered capital gains.
While capital gains are a type of investment income, they rarely occur on a regular basis. In addition, they cannot be depended upon as a reliable payment like dividends and interest.
There are two types of capital gains: short term and long term. A long term capital gain is used for investments older than one year and short term capital gains are applied to investments held for less than a year.
Capital gains are a taxable consequence. Long term capital gains are taxed at a lower rate than other income, including interest, dividends, and earned income. Short term capital gains are taxed normally, the same as interest and earned income.
Capital Gain Distributions
Investors of mutual funds (or an exchange-traded fund, aka ETF) may receive capital gains distributions from their investments. Such payments represent proceeds received by the investment fund from selling stocks or other assets.
Sometimes, an investor will declare a capital gains distribution on their taxes but do not receive any cash distribution from the event.
It is obviously a negative return when the investor declares taxes yet did not receive a cash distribution from that investment. Keep in mind that if the investment is in a mutual fund or stock, a portion can be sold to pay the capital gains distribution tax which results in a reduction in overall value.
You could own an investment that is operated and managed by another company (or individual) who pays you a royalty based upon the income they generate from that asset.
A common example of a royalty payment is when a musician receives a small percentage from each sale of their songs by a music company.
Nowadays, photographers can earn royalties every time one of their pictures is used by another company or website.
Other investments that can make royalty payments include operators of oil, gas, and mineral properties to owners of that land.
A new and exciting method of sharing profits in an investment is through revenue sharing.
Angel investing involves helping new investors in early startups when most other investors shy away from high risk.
In return for staking a newcomer, angel investors usually come in as a lender, sometimes with an equity conversion option.
The main goal of revenue sharing is to get a percentage of that top-line revenue. This means you get paid before everyone else!
Because of that, we call it “income angels” because of the heavenly yields you can earn!
Keep an eye for these opportunities since they can generate a hefty income in a short time.
The Power of Compounding
As you can see from the above examples of the different types of investment income, they are not equal. At the minimum, you should focus on investments that regularly and reliably make payments from profits.
The reason you want investments that make current payments is you can reinvest those earnings right back and get compound returns on your investments.
This means the income you earn on your investment also starts earning returns.
And like I always say, “I like the money that my money makes. But I like the money that my money's money makes even more!”
With the power of compounding, you can see your investment principle rise dramatically over the years, especially when starting young.
The Rule of 72
Want to know how quickly your money can double using compound interest? It's easy; apply the rule of 72.
By dividing your annual rate of return by 72, you can see how long it takes to double your money.
For example, if you earn 2% interest on a $100,000 investment and regularly reinvest your earnings, it would grow to $200,000 in 36 years (72 divided by 2 percent).
However, if you got an average annual return of 5% on that same $100,000, you'll reach $200,000 in just 14.4 years!
That is the power of compounding at work and at The Income Investors, we show you how to make the most of this incredible power!
Ready to start earning investment income? We'll give you some free stuff including an explainer video that walks you through the I12 Money Machine building process, our ‘Fill In The Gap' worksheet, and a FREE income investment idea to get you started. (Hey, the first one's free. That's how we get you hooked!