Many people are confused about the difference between “return of principal” and “return on principal.” Of course, they are both similar terms and only differ by one word. However, in the context of personal finance they are two related but different concepts that you need to understand in order to manage any type of comprehensive retirement or generational wealth planning.
What does “principal” mean?
In order to begin to understand the differences between “return of principal” and “return on principal” you will first need to understand the concept of “principal.” The term “principal” refers to the amount of money you initially put into an investment. This can be the capital you invested into a 401(k) or money spent purchasing stock shares in a certain company.
“Return of principal” vs. “return on principal”
The term “return of principal” means the return of your originally invested capital before counting any gains earned from the investment. Alternatively, “return on principal” refers to gains made from your initial investment, not including the original capital invested.
How return of principal works
When a person makes an investment, they are putting their money, the principal, to work with the aim of generating financial return. The amount of money that is currently being put to work is known as the “cost basis.” Return of the funds considered the principal is known as “return of principal” or “return of capital.”
How return on principal works
The gains that your invested capital will earn is known as your “return on principal” which is also referred to as “return on investment.” This does not include the original amount invested. For example, if you invest $1,000 in shares of Apple stock and the value appreciates to $1,200, your “return on investment” is $200.
Difference in taxation
The difference between “return of principal” and “return on principal” is important because they both have different tax consequences. Return of principal does not create a taxable event therefore you will not have to pay taxes on original capital you pull out of an investment. On the other hand, return on principal is liable for capital gains tax.
In the previous example with shares of Apple stock, if you decided to sell the shares you would be liable for capital gains tax on $200. However, the original $1,000 investment would not be taxed.
Certain types of investment vehicles allow you to pull out your originally invested funds prior to receiving your taxable gains. These types of investments are known as first-in-first-out (FIFO). Qualified retirement accounts, such as IRAs or 401(k) plans are examples of FIFO investment vehicles. Accumulated cash from permanent life insurance policies also falls under FIFO tax rules.
Choosing the right FIFO retirement instruments
Now that you have a basic understanding of how FIFO instruments work, you may be thinking about what type of FIFO retirement instrument you should look into for your own retirement planning. The options to choose will depend on your current financial circumstances and what you expect your situation will be by the time you retire. Working with a professional wealth management adviser can be useful in navigating through the various options available.
You should discuss any tax or legal matters with the appropriate professional.