Do you want to start investing, but find you're a little confused about how exactly an investment like stocks or bonds makes money? If so, you’re not alone. Portfolio income is the money you make from an investment account, and there are several ways to earn it.
In this article, you'll find out more about what this is and how to earn it. We’ll also go over the benefits of growing the income for your portfolio and how to deal with taxes from investments!
What is portfolio income?
Portfolio income is income earned from investment accounts. And income for your portfolio can come from a variety of investment sources.
Common accounts that earn this sort of income include retirement accounts, like a 401(k) or IRA, savings accounts, or a general brokerage account that lets you sell and buy investment products like stocks, funds, etc.
Other types of income
Typically, income falls into one of three categories: Earned income, passive income, and portfolio income. Below is a brief overview of the other two types of income for your reference:
Earned income is the money you earn from working (exchanging time for money), such as wages from a job or income from your small business.
Passive income is money you get from a hands-off venture, such as publishing an eBook and earning money with each sale.
Now you are aware of the different sources of income, let's delve further into portfolio income.
3 Types of portfolio income
Just like the different types of income, portfolio income itself is often divided into three categories.
Generally, the three categories from which you can make money on your investment portfolio are interest earnings, dividends, and capital gains.
1. Interest
Interest-bearing accounts often show up on lists of ways to make passive income. However, interest earnings are generally considered portfolio income rather than purely passive income.
For example, you have a savings account that earns interest. Last year, the account gave you $100 in interest earnings. The $100 is your portfolio income from the savings account.
2. Dividends
A dividend is a corporation’s profits given to its shareholders. Shareholders (owners of the company’s stock) receive dividends based on the number of shares they hold.
For example, you have 500 shares of company A. The company pays a yearly dividend of $1 per share. You receive $500 in dividend payments for holding 500 shares of stock.
Companies don’t have to pay dividends. The board of directors usually makes the decision.
The board of directors may choose to reinvest all of the company’s profits back into the organization rather than give out dividends.
However, many companies choose to pay dividends as an incentive for shareholders to continue owning the stock. In a lot of cases, companies pay dividends every quarter, meaning you receive a dividend payment four times a year.
3. Capital gains
Stocks, bonds, and other investment products are called capital assets. Whenever you sell a capital asset for a profit, you make a gain.
The difference between your cost of buying the asset and the amount you sell it for is a capital gain.
Let’s say you buy a stock at $50 and sell it later for $100. You made $50 in capital gains on the sale.
In some cases, you may also sell a stock or other investment asset at a loss.
Known as a capital loss, this means you paid more for the asset than you sell it for. For example, you buy a stock for $50 and sell it for only $25.
Account types to earn portfolio income
You can’t start earning portfolio income without an actual portfolio. So, your next step to making income from investments is to start investing.
First, you’ll need to figure out what types of accounts make the most sense for you. A few common investment accounts you can use include:
Retirement accounts
Retirement accounts include employer-sponsored accounts like 401(k)s as well as non-employer accounts like Individual Retirement Accounts (IRAs).
Brokerage accounts
A regular brokerage account lets you buy and sell stocks, bonds, and other investments on an investing platform.
Savings
Savings accounts and products like certificates of deposit (CDs) often earn interest, which is usually considered portfolio income.
Once you pick and fund accounts, you can start adding to your portfolio.
How to choose investments for your portfolio
Knowing what securities or investments to put into your portfolio is often intimidating for new investors. There are several types of securities products you can purchase. The most common include:
Stocks
Stocks or equities are ownership shares of a single company. When you purchase a stock, you are essentially buying a piece of a company.
Bonds
Bonds are a type of loan that's made by many individual investors to corporations, the government, and other organizations.
When you purchase a bond, you are essentially loaning money to the borrower in exchange for regular interest payments in return up until the maturity (or end) date of the bond period.
Mutual funds
A mutual fund pools your money with funds from other investors to buy multiple stocks and other securities.
This lets investors invest in many different securities without needing to individually buy each stock.
Exchange-traded funds (ETFs)
An ETF is a lot like a mutual fund in that it lets you invest in many different securities in one asset.
However, ETFs work more like individual stocks in that you must buy in shares instead of a specified dollar amount.
How to use portfolio diversification
Most financial professionals encourage investors to invest in several different types of investments.
Portfolio diversification involves choosing different types of assets that can help you potentially earn more from your portfolio over time.
Diversify with stocks and mutual funds
Diversification is also an important part of lowering your risk of losing money. By spreading your investments into many categories and types of securities, you’re less likely to lose significant funds in a downturn.
For example, individual stocks are generally considered riskier than mutual funds. That’s because you’re putting your entire investment into one company over many.
However, stocks sometimes have higher rewards than mutual funds.
By investing in both stocks and mutual funds, you give yourself a chance to take advantage of the benefits of both types of investment. At the same time, you lower your exposure to the risks of each.
Understand what risk tolerance means for you
Investing in securities like stocks and mutual funds is risky. No matter how “safe” or "diversified" an investment might be, it always has the chance to lose money.
Luckily, there are ways to lower your risk (in addition to diversification) when investing while still growing portfolio income.
Determining your risk tolerance
Your risk tolerance is your willingness to deal with market downturns — and your resulting losses.
In general, a higher risk tolerance lets you take advantage of riskier investments. This can pay off big if you invest in the next Apple or Google on the ground floor.
However, a high-risk tolerance also means you must be ready to stomach the downturns if your investments don’t turn out and you lose money.
Low-risk tolerance means you’d rather play it safer when investing. You’re willing to trade the opportunity for big gains in favor of less chance of major loss if the market drops.
Risk tolerance is simply a preference. And it’s unique to every individual and financial situation.
Not sure where your risk tolerance falls? Most brokerage platforms invite new investors to take an assessment when they open their accounts. You can also try an online risk tolerance assessment to get an idea of your risk appetite.
Reducing your risk tolerance
As I mentioned before, investing is always a risk, but there are ways to reduce your risk of losing money and portfolio income. Here are strategies that can help lower your risk:
In addition to using portfolio and asset diversification, these strategies can help lower your risk:
- Only start investing after you have a fully-funded emergency fund with easy-to-access cash in case of an unexpected expense.
- Think of investing as a long-term strategy — not a get-rich-quick scheme. That means being ready to ride out the lows in the market.
- Research assets before investing in them.
- Hold less volatile investments as a portion of your portfolio e.g. assets that are traditionally less volatile than the market like bonds.
Get a financial professional if needed
If you’re unsure of what to put into your portfolio, you may want to consider hiring a financial advisor. Contrary to popular belief, financial advisors aren’t only for the ultra-rich.
For instance, most robo-advisors — digital money managers that automatically invest and rebalance your portfolio based on your preferences — require only a small initial investment to start.
Growing portfolio income
While it’s important to reduce risks when investing, ultimately, you still want to make portfolio income from your accounts.
Earn capital gains
Some investors try to make all of their income from portfolios by buying and selling securities for capital gains. This could be a lucrative way to increase your income, but it comes with a lot of effort and risk.
You’ll have to regularly watch the market and immerse yourself in corporate financial reports to make the right moves at the right time.
Buy high-dividend stocks
There is a better way to earn long-term income from your portfolio by investing in high-dividend stocks. Although not guaranteed, assets with a history of paying dividends tend to continue doing so.
This means you can continuously earn money on your shares without buying or selling assets.
Reinvest your earnings
In addition to investing part of your portfolio into high-yield stocks with dividends, you can increase long-term income by reinvesting earnings.
Reinvesting means taking the money you make from your portfolio and using it to buy more assets.
Over time, reinvesting your earnings can help you build generational wealth for you and your descendants.
Portfolio income taxes: 2 Key things to know
As if taxes on your earned income from wages wasn’t confusing enough, there are often special rules for portfolio income taxes.
The good news? Some of these rules could potentially help you save money on your taxes.
Leverage tax-advantaged portfolios
Many types of investment portfolios are tax-advantaged. An account with tax advantages usually means you’ll either deduct your contributions from your taxable income or you’ll get to take out earnings with lower (or even no!) taxes.
Retirement accounts, health savings accounts, and educational savings accounts are often tax-advantaged.
For example, Roth IRAs and 401(k)s generally allow you to withdraw earnings from your account tax-free in retirement. Likewise, an educational account like a 529 savings plan usually lets you take out money for educational purposes without paying taxes on the earnings.
On the other hand, some accounts let you deduct your contributions from your taxable income when you file your taxes.
If you invest in a traditional IRA, for example, you may be able to deduct the money you put into the account from your income the next year. This lowers your total income and, thus, your tax burden.
As with any tax-related questions, it’s always best to talk with a professional. You may want to seek out a trusted tax advisor or accountant to help walk you through your individual tax situation.
Understand short-term vs. long-term capital gains
Remember when we talked about capital gains and losses?
If you sell an asset, like a stock, for a profit, that is a capital gain. A capital loss is if you lose money selling the asset.
Those capital gains and losses have tax implications. The exact tax rate you’ll pay (or be able to write off if you have losses) usually depends on how long you hold the investment.
There are two types of capital gains and losses:
- Short-term capital gains: These are generally assets held for less than one year. Most short-term capital gains are taxed at your normal income tax rate.
- Long-term capital gains: These are assets held for at least a year or longer. Long-term capital gains generally receive a flat tax rate that’s often less than your earned income tax rate. Depending on the income you earn, you may qualify for a 0% rate on some or all of your long-term capital gains.
Again, it’s best if you work with a tax advisor to figure out your capital gains tax implications.
Start building your portfolio income today!
The biggest benefit of portfolio income is the ability to grow wealth for long-term financial stability. If you continue to reinvest your dividends and earnings, you’ll increase the size of your portfolio.
In turn, this leads to owning more shares and enjoying higher dividend payouts.
So, when’s the best time to start investing? The answer is as soon as possible!
Of course, you want to make sure your immediate financial needs are met, but the sooner you start investing, the sooner you can make portfolio income. Over time, this can help you build wealth and improve your overall financial situation.