Did you know that there are different types of income? And did you know that it’s important to understand the difference?
Well, there are! And it is!
It can be tempting to just think “well, I make money, so who cares what type of income it is as long as I’m earning it”.
However, understanding the different types of income that are out there can have a massive impact on your future, especially if you plan on retiring one day (as you should!).
And don’t worry, this doesn’t have to be hard to do.
In fact, while there are literally thousands of ways to earn money, they all fit broadly into three types of income that you can use to plan your financial future.
So keep reading to find out what they are and why this matters for you!
Three different types of income
1. Earned income (also known as “active income”)
What’s earned income?
Earned income is what you earn by working. This could include your salary, your hourly rate, your consulting fee or what you pay yourself in your role as a business owner.
Essentially, if you work and get paid for it, you have earned income.
The tax question
This depends on where you live but, in general, earned income is taxed higher than the other types of income.
For example, if you’re in the US, the current Federal income tax rates vary between 10% and 37% depending on your income level and filing status.
This is in addition to the other taxes that will be imposed on your income, like those for Social Security and Medicare.
This means that you can end up very generously having to give a large portion of your earned income back to the government. How kind of you!
Pros and cons
Relying solely on earned income definitely has its pros and cons.
The main pro, depending on how you earn it, is that it can be the most stable type of income.
That is, as long as you go to work, you’ll (presumably) get paid.
It’s also, generally speaking, the easiest type of income to make. As long as you can get a job, you’re on your way – which is the main reason why this is the most common type of income.
Another massive benefit is that earned income generally doesn’t require any sort of start-up capital to start earning.
While you may have paid for some training, like a college degree, you can go straight into a job for free.
This is largely why most people make money from earned income at the start of their careers and also makes it a great way to earn money to help you take advantage of the other types of income, like giving you money so you can start to invest.
At the same time, there are some down sides with earned income.
For example, you’re limited by the number of hours you can work.
You have to sleep at some point, not to mention that your employer is probably only open at certain times of the day.
Or as an even worse scenario, you may be fired or something like a medical condition could prevent you from working.
Either way, once you stop working, the money stops too.
This also means that it’s harder to make more earned income without working longer hours – or without training for a new or better skill, which itself takes time and often money.
So in summary…?
Most of us make our money from a job, which lets us make earned income. While this is fine, it can be risky, not to mention exhausting. We also don’t have a whole lot of control over how much we earn using this income source.
One great way to address all of these possible concerns is to add another income stream, like one of the types of income mentioned below.
Keep reading to see just what this entails!
And if you’re looking to increase your earned income, take a look at these articles:
- 11 WORK FROM HOME JOBS TO MAKE MONEY ONLINE
- 24 FUN AND CREATIVE HOBBIES THAT MAKE MONEY
- 23 OF THE BEST JOBS FOR STAY AT HOME PARENTS
- 30 CREATIVE WAYS TO MAKE $100 EVERY DAY
2. Portfolio income
What’s portfolio income?
Portfolio income is any money you make from selling an investment for more than you bought it for.
This can include any asset, like stocks, bonds and other investments, real estate or anything else you can sell, like jewelry or a car.
The tax question
The tax to be paid on portfolio income (known as “capital gains tax”) can get complicated, so it’s best to seek specific advice from an expert if you think you have earned portfolio income that’s taxable.
Essentially, in summary, capital gains tax rates are between 0% and 20% on assets held for more than a year. For assets held for less than a year, the income is subject to the same tax rates as earned income above.
That said, capital gains tax on real estate in particular has a number of other factors to consider, like if you’ve lived in the property and for how long. You can find out more on this here.
The big plus on capital gains tax, besides the reduced rate if you own the asset for more than 12 months, is that the amount of tax you pay can be offset by any losses you incur on other investments.
This is great for people who invest in shares, for example, as if some go up before you sell while others go down, your overall tax rate will end up being lower.
It’s also not subject to other taxes, like Medicare and Social Security are on earned income.
Pros and cons
Earning portfolio income can seem really scary at first.
You probably have images of the Wolf of Wall Street in your head, with people screaming at flashing numbers on screens or Gordon Gekko strutting through an office lecturing us about how greed is good.
And it’s true that getting started with investing does take a bit of a learning curve.
After all, if you just throw your money at the first investment opportunity that comes your way or buy some shares because your neighbor’s son’s cousin’s friend heard that it’s a great deal, then chances are that things aren’t going to go well for you.
Not to mention that you have to have money to make money this way, which is why earned income is probably a better place to start.
It’s also not always the fastest way to make money. You may have to wait years or even decades for your investment to reach a value where you’re willing to sell.
But investing – or making your money work for you – is one of the best things you can do for your financial future.
To see just why this is, check out this article on how compound interest is the best way for you to get rich with minimal effort.
There’s a reason why the vast majority of the richest people in the world built their wealth through investments and compound interest is the main reason why.
Of course, there are risks – the biggest one being you if you lose your nerve and sell when things are getting a bit rocky.
That said, the potential benefits for your future make it absolutely worth your time to find out how to get started as an investor.
You may even be surprised to hear that it’s not complicated at all, especially if you choose to invest in index funds like I have.
(And many others are doing the same apparently, given that investments in index funds now account for nearly one-third of all investments in the US, which is equivalent to almost US$6 trillion.)
If you’re not sure what an index fund is or really have no idea how a normal, everyday, wannabe investor like yourself can get started, I’d recommend checking out our free e-book: How To Start Making Your Money Work For You.
It gives you a simple, jargon-free explanation on how to start investing – and will also point you in the direction you need to learn more on what you can do to take advantage of this type of income.
So in summary…?
Portfolio income is a necessary type of income for anyone who wants a secure financial future as it lets your money increase over time without you having to work for it.
It can certainly be intimidating to get started and there are risks involved, so you’ll have to be prepared for some ups and downs.
You’ll also need another source of income (like a job) to make this work, especially at the start.
But it’s absolutely worth your time to figure out how to make this happen – especially if you’re planning to retire at some point.
3. Passive income
What’s passive income?
Passive income is money you earn from assets that you’ve either purchased or created.
This means that it can include things like rental income from your investment property, business income (unless your earnings are based on the time or effort you’ve put into the business, which would be earned income) or creating and selling things, like books and online courses (meaning you don’t need to teach them in-person to keep earning money from them).
The tax question
Again, while it depends on where you live, passive income generally gets very favorable tax treatment – certainly more so than earned income.
That said, there are a range of factors that can affect your actual tax rate on passive income earned (as well as whether the tax authorities even consider something as being passive income), so it’s best to speak with a tax professional, especially to see how you can qualify for tax deductions.
Pros and cons
Passive income is one of the best types of income that you can rely upon for securing your long-term wealth.
The main reason for this is, ideally, you’ll keep earning money from the asset once you’ve done the work to create it or after you’ve bought it, often with minimal ongoing work required on your part.
While it’s unlikely that you’ll make enough money at the start of owning a passive income-producing asset to sustain yourself, meaning that you’ll probably need to continue earning earned income for a while, passive income can quickly build up to a level that far exceeds earned income.
You’ll also need some money to get started, although not as much as if you aim to earn money from portfolio income.
For example, I earn passive income from this blog. While it takes some ongoing work through things like writing articles and answering emails, I continue to earn money from it even when I sleep due to the fact that people continue to visit the site even when I’m not actively working on it.
And this is a classic example of the minimal start-up costs required! For example, my hosting costs for this blog are less than $4.00 per month with Bluehost meaning that I continue to earn passive income for less than a monthly cup of coffee!
If you’re interested in doing the same, check out How To Start A Blog In Less Than 15 Minutes.
And to see the sheer amount of passive income you can earn from this source, take a look at what these bloggers earned after only 12 months of owning their sites.
(One of them now makes over $1.5 million per year just from her blog!)
It really makes you think what you could be earning only one year from now…
So in summary…?
There is seriously good money to be made from passive income and it can also be much more secure, given that it’s not dependent on you actively having to work.
It’s also hard to put a price on the freedom that this can bring you. Just think of all those stories of bloggers working from beaches around the world.
That said, it’s not risk-free. While you’re going to be paid if you go to your office job, there’s no guarantee that your book will sell or that your rental property will be rented out all year round.
That’s why it’s important to maintain your other types of income when building up your passive income source.
For me, that means that I have a “real job” at the same time as working on this blog.
For others, it may mean sticking to your 9-5 while saving up enough for a rental property or doing shift work at night and writing your book during the day.
There’s no question that this can be hard work, especially if you have other commitments like family members to care for. Not to mention sleep.
But it can absolutely be worth it if you build your passive income source up to a point where you don’t need to make earned income.
Why do I need to know about the different types of income?
You may have gotten this far and are still thinking: “That’s great. But how does knowing about the different types of income actually help me make money?”
And the answer is: Because as cliched as it sounds, knowledge is power. And you can use this specific knowledge to set up your financial future.
After all, you’ve probably heard the saying:
“If you fail to plan, you plan to fail.”
And the same definitely applies for your finances.
That is, if you intend to simply keep working at your job for the rest of your life, not really knowing where to put the money you earn so you just park it in an everyday checking account earning barely any interest (or, worse, spend it all), then you’re pretty unlikely to have a secure financial future.
On the other hand, you could tell yourself that you’re going to work to make earned income now on the understanding that you’ll save, say, one third of your income over your working life and put it into index funds to earn huge amounts of interest.
Or perhaps you’ll set a goal of working at your office job for the next two years during the day while creating a website at night that you’ll use to start earning passive income, with the aim of relying solely on your passive income by the end of the two-year period.
Whatever your goal, it can be far too easy to simply slip into the easiest option, which is to work for the rest of your life while looking at people with true wealth and wondering just how they do it.
So being aware of the different types of income makes you see just how it can be done.
That you, too, can absolutely generate wealth and that financial security isn’t limited only to those people who have “figured it all out”.
In fact, knowing about the different types of income doesn’t only give you security because of ideally helping you to make more money.
It also means that if one of your sources of income isn’t available, like if you get sick and can no longer work at your current job, you’ll have other sources to get you through any hard times.
Either way, it’s worth saying again: Knowledge is power.
And knowing how to use your time and money to get closer and closer to financial freedom is pretty much as powerful as it gets.
What are the different ways that you’re planning to earn money – and how do you plan to make it happen?