As a general rule, investors make their money from one of two types of return. A capital return is one that the investor enjoys when they dispose of their investment asset. To give a simple example: if you buy a parcel of shares worth $100,000 and sell them 12 months later for $110,000, your capital return is $10,000 or 10%.
A capital return can be negative. That is, you might find that you can only sell your investment asset for an amount less then the asset was purchased for. In the above example, if you sold the parcel of shares for $90,000, your capital loss is $-10,000. Put another way, the return is -10%.
With assets such as shares, it is possible to know that an asset has risen in value even before you sell it. For example, if the parcel of shares that was bought for $100,000 has a current market value of $110,000, then the investor knows that they could sell the shares for that price if needed (this assumes things like market liquidity, et cetera, which we will do for the purposes of this example). In this case, the capital gain is often referred to as unrealized. As that name suggests, an unrealised capital gain is one that the investor has not yet got their hands on.
The other type of investment return is an income return. An income return is one that the investor enjoys while they continue to hold the investment asset. For shares, the income return comes in the form of dividends. For property, it comes in the form of rent. And for cash or cash equivalent investment (such as a term deposit) it comes in the form of interest. An income return can fall to zero but it cannot be negative.
The income return is typically expressed in percentage terms. That percentage is the income return divided by the purchase price of the asset. So, if a parcel of shares purchased for $100,000 provides a dividend to the shareholder of $4000 per year, the income return is said to be 4%.
Different types of return are taxed in different ways according to various criteria. These criteria include the period over which an asset is owned and what type of taxpayer the asset owner is. For example, an individual who owns an investment asset for more than 12 months will generally only have to pay tax on 50% of any positive capital return that they enjoy.
Because of these differences, different investors often prioritise income return and capital return differently. As a general principle (and we’re speaking very generally) capital returns are taxed more generously. In most cases, this is to encourage people to hold onto assets for extended periods – which is why many (but not all) investors who own assets for more than 12 months only pay tax on half of their capital return.
Another factor that dictates the relative priority given to income and capital return is whether an investor needs cash from their investment to fund their lifestyle. For example, a self-funded retiree may need to withdraw cash from their investment to meet their daily living expenses. If that is the case, they may prefer investments to be skewed more towards those that provide high levels of income return rather than capital growth.
As you can see, the issue of which type of return to prioritise can be complicated. We always encourage clients to talk to us about the role that their investments need to perform within their overall financial plan. So, please, do not hesitate to contact us and let us discuss the important concepts of income and capital return with you.