Investors put money to work with an eye toward making money, called return on capital. But there’s another kind of return, called return of capital.
The difference is important because of how taxes are calculated on an investment.
Normally, investors must pay capital gains taxes on money they make through investing.
The rates vary based on how long you hold the investment. If you buy and sell a stock in less than one year, that’s a short-term capital gain.
If you hold the stock for more than one year and then sell, it’s a long-term gain. Tax rates are lower on long-term gains.
Similarly, dividends or bond income from an investment is taxed at a different rate altogether.
However, some investments are structured to return a portion of the original investment along with any gains. The returned capital is not considered a gain since it’s a return of your own money. Thus it is not taxed at all.
The effect of returning capital is to reduce the cost basis of the initial investment. For instance, if you buy a stock at $10 and sell it at $20, your cost basis is $10. Your taxable gain is the other $10.
If you were to invest in a permanent life insurance plan, however, you might pay a premium that is in turn invested. The invested cash grows and adds to the balance.
Over time, your premiums can be refunded to you first, creating income in retirement that is not taxed as gains, since it’s your money being returned to you.
Once those premiums are paid back, the remaining gains are taxed.
In another example, let’s say you buy a stock for $10 and then sell it later for $10. Since there’s no gain, 100% of the money you get back represents your original investment. No taxes are collected.
Similarly, if you invest in a business that makes a profit, money taken out of the company equal to your initial investments is return of capital. Any money taken after that is return on capital and thus considered taxable.
It’s very important to carefully track cost basis in any investment, since your tax bills you receive will be based on the gains you record above and beyond cost.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.