How do my investments create income?
Investments are made with the hope that they will generate income. For example, if I purchase a certificate of deposit (CD) at the bank, I expect to receive an interest payment. And if I invest in a corporation that operates grocery stores, I expect to receive a portion of that corporation’s profits.
In a previous article, I said every investment asset is backed by debt or equity (AKA ownership). These capital structures create different types of income; debt pays interest and equity pays dividends.
A third type of investment income -- known as a capital gain -- occurs when you sell an asset for more than what you bought it for.
In this article I will explain the different types of income and the assets that produce them. I will also discuss how we use this to create a retirement paycheck.
In a future article, I will dive into how this income is taxed, and how you can avoid (or defer) the tax.
“Debt pays interest; equity pays dividends. Either one can be sold for a capital gain.”
Interest
When you put money in a savings account, or purchase a municipal bond or a Treasury Bill, you are lending money to whoever issued the account, bond or Bill. These entities will pay you interest, just like you pay interest to the bank when you borrow money for a house or a car.
Investments in debt are generally considered safer than investments in equity, as the interest payments are contractually guaranteed. However, that same guarantee also limits the upside of your investment. Thus, debt investments are seen as low-risk, low-reward.
Debt investments can be made directly with the issuer, such as buying a CD from a bank or a US Treasury Bill from TreasuryDirect.gov. When you buy this way, your investment will have a stated interest rate and maturity date. On the maturity date, the issuer will give you back (redeem) your initial investment, known as principal, and you will have to make another purchase to continue receiving interest.
A common alternative to direct investment is to invest in a mutual fund. A mutual fund is a middleman that collects money from thousands of investors and in turn makes direct investments. They collect the interest payments and pass them proportionately to the investors. Mutual funds charge a fee, which is displayed on their website and prospectus.
Mutual funds allow average investors to invest in a wide range of debt, which prevents you from keeping all your eggs in one basket. They also will manage purchases and redemptions for you, so you no longer need to worry about maturity dates.
Dividends
A corporation has revenue, and it has expenses; the difference between the two is known as profit. The corporation usually retains some profit to reinvest in the business, and the rest is sent to its equity owners (known as shareholders) as a dividend.
In general, newer companies (e.g. Tesla) reinvest all their profits into growing the business, while older and more established companies (e.g. Chevron, General Mills, Home Depot) distribute some of their profits as dividends.
A notable exception to this rule is Berkshire Hathaway. Though it is an old and established corporation, Warren Buffett’s philosophy is, instead of paying a dividend, shareholders would prefer he re-invest the profits to increase the value of the company.
Equity investments can be made directly with the corporation, but normal investors like you and I must buy them secondhand on the stock market. Online brokers such as Schwab, Fidelity, Robinhood, and Vanguard enable you to invest in any publicly traded corporation from the comfort of your own home.
A mutual fund is an easy way for average investors to invest in hundreds of different corporations. There are thousands of mutual funds available to invest in, so make sure you do your research before making a purchase.
Capital gains
A capital gain occurs when you sell an investment for more than you bought it for. For example, if you buy ABC stock for $100, and sell it for $109, you will have a capital gain of $9.
Capital gains also come from mutual funds, where buying and selling within the fund creates capital gains that are passed to shareholders.
Capital gains are taxed only when the asset is sold, known as “realizing the gain”. In the past few years, some politicians have proposed a tax on unrealized gains (i.e. potential gains on assets you still own), but that is not likely to happen soon (in my opinion).
Putting it into practice
You may be wondering what the best way is to generate income from investments. In practice, most people utilize a combination of all three.
Some people strive to live on dividends and interest only, and to never spend the principal of their investments. In reality, it takes a very large account balance to fund retirement without selling investments.
If you don’t spend down your assets, you may be underspending. You may be doing less and creating less memories than you can afford to. A successful retirement investment plan can – and often does – include prudently spending down principal to generate income.
About the Author
Joseph Fowler, CFP® is a financial planner and co-owner of 402 Financial in Lincoln, NE.
402 Financial provides financial planning and investment management services to people approaching or in retirement. Joe always acts as a fiduciary and never takes commissions on product sales.
Click this link to schedule a free consultation with Joe.
