Making money is one thing, but what do you do with it is another issue altogether. It can be a struggle for some to know how to handle investment income, whether it be from interest, dividends or capital gains.
When you receive investment income, it is important to handle it in the correct manner. This guide will walk you through a few tips on how to handle new income derived from investments.
What to do with Investment Income
You’ve just had a great year. Your investments have soared in value and you’ve earned a bundle of interest and dividends. You’re about to receive an investment income windfall so big that you’re going to need some financial advice on how to handle it.
First, congratulate yourself on your good fortune and remind yourself of how rare your situation is. Most investors suffer through years in which their investments lose money or eke out little more than inflation-level gains. But you are fortunate enough to have made some smart investment decisions, or been lucky enough to be at the right place at the right time, or both, to have enjoyed a year of exceptional returns.
Second, decide if you should sell any of your investments before year-end. If you own stocks that have soared in value this year, take a hard look at them and consider whether they might be vulnerable to a decline after you receive your income distributions. If you think a particular stock or bond might be headed for trouble, sell it now (or as soon as possible) and pocket any capital gains by Dec. 31. You can use those gains to offset capital losses from other sales during the year or apply them against up to $3,000 in ordinary income this year.
Third, get ready for your taxable income distributions. These payments may arrive as cash deposited into your account or as checks sent through the mail; sometimes they are reinvested directly into additional shares of the fund (in which case the cost basis of these new shares will be adjusted downward).
But before you pay any taxes, determine whether you can minimize your overall tax bill for the year by postponing income into next year and accelerating deductions into this year. You might be able to do that by, say, delaying the sale of a stock until next year or by waiting until January to collect on an investment note that matures this month. Or maybe you can increase your charitable donations so they are larger than the standard deduction.
If neither of those possibilities applies in your case and you have time between now and Dec. 31, consider investments that will generate deductible expenses, like home mortgage interest or property taxes. If you itemize deductions on Schedule A of Form 1040, such deductions reduce your taxable income dollar for dollar.
Although there’s no single investment that offers the best tax treatment for everyone, if you’re in a high tax bracket and plan to spend more money for big-ticket items in the next few months — like perhaps a new car or even a larger home — look into municipal bonds (also known as munis). These state-issued bonds generally offer interest income that is free from federal income tax and often exempt from state and local taxes as well. Most muni bond issuers are either state governments or agencies or local public utilities.
Most Important Principles
When it comes to investment income, the first principle is to avoid debt. You may disagree with this on the grounds that you think it’s ok to be in debt to a bank. I think this is a moral hazard, because in practice it makes you too willing to take risks. But let’s not argue about that now. Let’s just stipulate that we won’t borrow money.
The third principle is similar: save your investment income.
A fourth: invest your savings.
What do these principles add up to? They add up to saying that when you get income, you should save some of it and invest the rest in reasonably safe investments that are likely to appreciate at more than inflation, like stocks. This is the same as saying you should put your income into an investment portfolio, which strikes me as obvious even without these four principles; but if they help you understand why this should be obvious, or make it seem less scary, then great.
Now, let’s talk about the fourth principle – investing your savings and investment income. If you are lucky enough to have investment income, that makes it easier to get rich. But the fact that the money is “passive” does not mean your work is done. You still have to make decisions about how to invest it.
The most important things are the same whether you own a little or a lot. If you want to maximize your chance of having a lot, you should do the following:
- Invest in assets that will grow faster than inflation
When you invest in assets that grow faster than inflation, you are guaranteeing that your money will lose value over time. Even if the asset goes up in value, it will not go up as fast as inflation.
The best example of this is a bond. If you buy a bond for 100 dollars and hold it until maturity, then you will get 100 dollars plus interest. The interest rate is set at the time you buy the bond, so there is no risk. But if inflation goes up, then the purchasing power of your money declines even though you are guaranteed to get back exactly what you put in. Inflation makes bonds a bad investment over any period of time greater than a few years.
- Diversify your investments
If you own a single stock and the company does badly, you lose. But if you own a hundred different stocks, it’s very unlikely that all of them will do badly at once. For this reason, mutual funds have become popular. A mutual fund is just a collection of stocks and bonds.
To be really safe, it’s best to diversify across asset classes as well as individual investments. If everything in your portfolio is in stocks, and there’s a crash, everything in your portfolio will go down together. Bonds are generally better in a market crash; if you have both stocks and bonds, they help each other out. Diversification also means spreading your bets geographically: don’t put all your money into one country, or even one part of the world.
- Never put significant money into something you don’t understand
Whether you are investing in stocks or a rental property, you should understand how it makes money and how it doesn’t. If you don’t understand, don’t invest.
- Invest for the long term
Always think long-term—at least five years ahead, preferably much more—and don’t panic when there’s a downturn or bad news comes out about some company you’re invested in.
Conclusion
Investment income is the only kind of income you can earn without working. The other kinds are all either directly or indirectly tied to your work. If you want to earn more, there’s only one way: invest more and diversify.
