Portfolio income is interest, dividends, or capital gains derived from investments or money lent.
Royalties also tend to be categorized as portfolio income.
Passive Income and earned Income are not portfolio income.
Another way to distinguish portfolio income is to think of it as income from “paper assets”.
The term “paper assets” comes from the fact that owners of these types of assets generally have a piece of paper signifying their ownership. A classic example is a stock. Once upon a time, a person would receive an actual certificate of stock ownership. Today ownership is recorded through third party custodians, however the term “paper asset” remains.
So how does a paper asset pay income?
Just like an investor in a privately-held company can receive a distribution of profits, owners of paper assets can also receive distribution in the form of dividends and interest.
They seem similar, and they are, but the publicly-traded stock is a paper asset and therefore portfolio income, while the distribution from the privately-held company is passive income from a business activity (i.e. limited partnership).
Examples of Portfolio Income
Interest - money paid at a particular rate on a checking/savings account, money market, Certificate of Deposit (CD), or Bond. For example, a CD or Money Market Account might pay 1% per year, so for every year you left your $100,000 in the account you would receive $1,000.
Dividends - a return of profits to a shareholder (owner in a company). For example, let’s say you own shares of ABC Company and they pay a 2% dividend. That means if ABC’s stock price is $50, you would receive $1 for every share you own.
Capital Gains - money paid out with something is sold at a profit. For example, you bought XYZ company (or fund) at $40/share and sold it at $60/share. The $20 profit is a capital gain.
Why is Portfolio Income Important?
Portfolio income is important because it is the primary driver of financial freedom for most Americans.
401(k)s, IRAs, and other types of accounts are designed to assist in the accumulation phase of an investors life, but eventually the goal is for those accounts to be converted to income.
So during your working years you can reinvest your interest, dividends, and capital gains. Then when you are ready, you can take those out each year and preserve your principal.