There are two major reasons you invest; for cash flow or for capital gains. What’s the difference between cash flow and capital gains investing? Cash flow investing buys assets that generate income while capital gains investing buys assets with the expectation they will increase in value.
There are some important nuances with both cash flow investing and capital gains investing. For example, the term “cash flow investing” is often loosely used for investing in income generating assets. And many investments can have both cash flow and capital gains as you’ll see.
This article will address these important factors and more so keep reading. I also made a chart outlining the differences between cash flow and capital gains investing which you can reference.
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Major Investing Focus
The primary differences between cash flow and capital gains investing are reflected in the results you get from doing each.
What Is Meant By Capital Gains?
A capital gain occurs when an asset increases in price above the purchase price. If the asset is sold, the capital gain is realized. If the asset is held, the capital gain is considered unrealized.
What Is Meant By Cash Flow Investing
Cash flow investing refers to investing in assets that generate cash, or income. Retirees and those wishing to live off investments prefer cash flow investing while most younger investors are seeking to build wealth from capital gains.
Cash flow is officially an accounting term that applies to how cash flows within business accounts. In recent years, however, the term cash flow investing has grown popular referring to investing in income generating assets.
The Difference Between Cash Flow and Income Investing
The main reason for cash flow investing is to provide funds to cover expenses, although some investors invest the income instead of spending it which increases net worth, thereby increasing wealth from that income. On the other hand, the main reason for capital gains investing is to buy assets that increase in price during ownership so they can eventually be sold for a profit.
Timing for Cash Flow Vs Capital Gains Investing
Another major difference between cash flow and capital gains investing is in how long it takes to accomplish the desired result.
Cash flow investing is also referred to as income investing since income is the main goal. The goal from cash flow investing is accomplished when the investment income flows into your account, which is often monthly or quarterly, depending on the investment. Real estate rentals and bond interest income may flow in monthly, for example.
Income can sometimes be received immediately after an income generating asset is purchased. For example, dividend income may be received within a day of buying a stock.
On the other hand, accomplishing the goal from capital gains investing often takes years. While there are exceptions, such as flipping real estate, swing trading, or short term stock trading vs investing, capital gains are usually associated with buy and hold investing.
Capital Gains Vs Income Investing and Taxes
Taxation is treated differently among the various aspects of both cash flow and capital gains investing but the two investing methods can also overlap when it comes to taxes.
Taxes are an important but often overlooked factor for investors to consider when choosing between cash flow and capital gains investing. There are many variables that affect how taxes will affect your investing results from either method so let’s look at this more.
Tax Favored Accounts
Investments made for cash flow are usually owned in a different type of account than capital gains investments. For example, capital gains tend to be held more often within a tax deferred account or a tax free account, such as an IRA or 401K.
On the other hand, income producing assets are often held outside a tax advantaged account. This is because, otherwise, the income would be “trapped” inside the tax deferred (or tax free) account. When this happens, the income cannot flow out to the investor unless a deliberate or mandatory withdrawal is being made from the account, such as an RMD (Required Minimum Distribution). This is, of course, assuming the investor wants to make withdrawals and live off investment income.
Cash Flow Investments with Tax Benefits
Also, cash flow strategies can have benefits that lower overall taxes from investments based on the strategy itself, as opposed to just where the asset is held, such as in a retirement account. For example, real estate rental ownership has the benefits of depreciation write-offs and 1031 exchanges that investors may use.
Another tax benefit example is when cash flow investments have tax benefits as a result of being structured as an entity such as an S Corporation, which is common with small business.
And of course, qualified dividends are also subject to a lower tax rate than earned income.
Capital Gains Taxes
Those are some of the potential tax benefits from cash flow investing. Then there are also the tax benefits that apply to capital gains investing when the gains are long term gains and subject to a lower tax rate.
Note, however, that the long term capital gain tax benefit can apply to both cash flow investments, such as real estate, and capital gains investments, such as growth stocks, when these assets are sold for gains; the assets just happen to be income generating assets that produce cash flow for the investor.
You can see how much a role taxes play how much investors get to keep from their investment earnings, whether from cash flow or capital gains investing.
Bull and Bear Markets
Since the primary goal of income investing is getting paid income, goal achievement from cash flow investing is usually less affected by economic and market cycles. While the value of the asset that generates the income often drops as a result of a bear market or recession, if the income continues to be paid, the goal is accomplished as long as the income keeps flowing in from the investment.
For example, a stock paying a reliable 5% dividend will likely continue to do so even if the value of the stock drops from $100 to $60 during the occasional bear market.
On the other hand, capital gains investing is very tied to economic and market cycles since accomplishing the desired result is dependent on the asset increasing in price.
In other words, if an investor buys a stock for $100 and it drops to $60, the goal has not been accomplished if the investor sells the stock. Of course, the investor can continue to own the stock. If it recovers and exceeds the investor’s cost, a capital gain may be incurred. The time frame for this, however, is very unpredictable, and the gain may never be achieved.
Acceptance of Cash Flow Vs Capital Gains Investing
The most promoted method of investing among financial firms and the media is to buy stocks for long term capital gains. This is the easiest way to invest and it can work very well over long time frames.
Long term buy and hold investing is what most financial advisors do. It’s promoted both in the media and by icons such as Dave Ramsey, and even Warren Buffett, although neither of them got wealthy from passive capital gains investing.
Cash flow investing is considered more alternative or suitable for retirees. Many cash flow investing methods take more effort than simply buying an asset with the hope that it will increase in value. In general, investors like to go with what is most common and easiest for logical reasons.
And many investors are just not aware of cash flow investing because of the overwhelming influence of mainstream buy and hold investing. This trend, however, seems to finally be changing with the FIRE (Financial Independence Retire Early) movement among the younger generations and their affinity for alternative income generating assets that older investors aren’t as comfortable with.
Age Difference for Cash Flow Vs Capital Gains
Based on traditional investing methods, however, most young people focus on capital gains investing while they are employed. This is because they usually already make enough money to cover their living expenses from their jobs.
On the other hand, cash flow investing can be the best choice for income in retirement. The newer trend, however, is toward early retirement from investments that generate cash flow for many younger, more advanced investors.
In my video below, I talk more about retirement income with cash flow investing.
Predictability
One last difference between cash flow and capital gains investing is how predictable successful results are.
Cash Flow Predictability
With cash flow investing, a successful outcome is more predictable for many investments than capital gains are. This is because it is easier to see the likely income from an investment than it is to predict whether an asset will increase in price while you own it.
For example, you can see how much dividend a company pays, or how much rental income a property will generate. This is true from among the many types of cash flow investments. Income can change, of course, but it can be estimated with a more reliable and acceptable degree of accuracy than capital gains can. You know within a high level of certainty that when you buy a stock reliably yielding 5% those dividends will be deposited into your account, unless, of course, the dividend gets cut, which occasionally happens.
Capital Gains Predictability
On the other hand, the value of a non dividend paying growth stock or index fund could drop and you don’t get the intended capital gain.
Of course, having an awareness of and investing around economic and market cycles increases the predictability of capital gains. It is for this reason I address the importance of having an awareness of such cycles in my work at Retire Certain.
Are Capital Gains Considered Cash Flow?
Many investors now consider regular and recurring capital gains as cash flow investing. I now invest a portfolio strategy using primarily short term capital gains as explained in my Allocate Smartly review, for example, and I view the gains like income given the predictability of the strategy based on 50 years of back tested results.
Theoretically, if profits are being consistently generated, they can be used for income purposes. For tax purposes, however, capital gains have different treatment than income generated from cash flow investments.
Maybe it’s the old accountant in me, but I differentiate capital gains from cash flow as a primary investing goal. Capital gains are one thing and cash flow is another.
Should I Invest for Cash Flow?
As a financial coach, clients often ask if they should invest for cash flow.
Investment selection should stem from an overall wealth plan that defines whether income or capital gains is the primary goal at any given time. If the main investing goal is income generation at a given life phase, then cash flow investments usually make the most sense. If an investor is in the accumulation, or wealth building phase, investing for capital gains as a primary goal makes the most sense.
Of course, I promote that ceasing attempts to build wealth in retirement is somewhat ludicrous since no one really wants to get poorer as they get older, and predicting the longevity of retirement savings is just too hard and uncertain.
Summary
While there are major differences in cash flow and capital gains investing, they don’t have to be mutually exclusive. When investors buy cash flow assets that also generate capital gains over time, they can both pay the bills and build wealth from the same assets. Now that’s what I call a double wealth builder.
Learn about my triple and quadruple wealth builders in my Ultimate Wealth Plan. You can get it here now.
