Disclaimer: The statements made in this post are the opinion of the author. They should not be viewed as financial advice. Please consult with a financial specialist before making any financial decisions.
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You might be vaguely aware that people who are extremely wealthy don’t go to work every day for 8 hours to get a paycheck at the end of the month.
The wealthiest people don’t just live off of a huge wad of cash in the bank though.
You’re also probably aware that some day you’ll be retired and won’t have to work any more as well.
This is even possible without social security.
The reason rich and retired people don’t have to work is because they don’t need work income. They have different types of income.
If you want to be wealthy, or just want to be able to retire comfortably, then it is probably best to understand the three different types of income and how to get them.
What Is The Meaning Of Types Of Income?
To break it down, income is just any time money comes into your pocket. That can be in the form of wages, rents, gifts, sales, commission, rebates, stimulus, refunds, bonuses, rewards, winnings, royalties or otherwise.
Since there are so many different ways to earn income, it is helpful to group similar income sources together.
There is little you can do to influence gifts, inheritances, refunds, winnings, and things like that. These are all unearned income (unless you’re a professional poker player) so we won’t include those in our three types of income.
When someone asks “What is the meaning of types of income” they are asking how do you separate each type of income into groups. The way you separate the types of income is to group them by the effort that goes into making that money.
So we’ll group them by how it is earned.
3 Types of Income
To cut to the chase, the three types of income are Active income, which is earned through time put in, Portfolio income, which is earned through money invested, and Passive Income, which is earned for work previously put in.
As I said before, active income is earned by putting in time. It is the living meaning of the expression “time is money”. The more you work the more money you’ll make. The less you work the less money you’ll make. It is that straight forward.
This category covers most of the work done by most people in the world.
The truest active income is the hourly wage because there isn’t paid time off. But the salaried worker isn’t much better. They must continue their employment to keep making their money.
This category also includes gig economy workers who only get paid for each service they provide and self-employed workers who, even though the own a business, can’t leave that business since they are the only thing keeping the lights on.
So one way or another that includes the vast majority of people.
- A fast food worker (hourly)
- A government employee (salaried)
- A doctor with their own practice (self employed)
- An Uber driver (gig economy)
- A corporate employee (salaried, or hourly)
- A realtor or salesperson (commission/self employed)
The biggest benefits to active income are how easy it is to make money and how consistent the income is–usually.
To start making money all you have to do is get a job, or a gig, and start working. Within two weeks or maybe a month you’ll have a paycheck coming in.
You can rely on that paycheck coming in consistently. Usually it is about the same amount from month to month.
And besides that, the more time you put in the more money you make, usually. It is straight forward and simple.
Taxes. Those pesky things. It turns out that, if you want to avoid taxes, having a regular job is a terrible idea. Earned income is taxed at a very high rate and there is no way around it.
Of all of the ways to earn income, active income has the highest tax rates. So be aware of that.
It is also time consuming because you are trading your time for money. 40 hours a week is just under 1/4 of ALL your time in a week (including the 1/3 that you spend sleeping and the weekends).
If you want more of your time to yourself then this isn’t a great option.
And you’re likely to be stuck in the consumer cycle. Working to live each month, paycheck to paycheck, stuck in debt. Active income encourages living paycheck to paycheck. So if you want to get out of the rat race then you need to be smart with your active income.
Portfolio income is money earned through investing. So another way to think of it is money goes in and (hopefully) more money comes out.
Any type of investment the average worker makes, like into a 401k, will be (mostly) for portfolio income. Another way to talk about portfolio income is called capital gains.
The way it is calculated it the price you bought it for minus the price you sell it for equals your total income.
That’s how stocks work, and it is how most retirement funds are funded.
Basically a portion of all the stocks you own are sold off every so often and the amount they are sold for is what you are getting as a retirement check.
- Stocks (buy low and sell high)
- Commodities (like buying gold)
- Real Estate Appreciation (Selling your house for more than you bought it for)
- Bitcoin (As the price goes up your original investment increases in value)
Unlike active income, portfolio income is taxed at a rather low rate, as long as you hold it for the long term. So if you bought bitcoin over two years ago and just sold it you’d get a pretty low tax rate (comparatively).
Just make sure you don’t sell too early or you’ll get hit by short term capital gains tax which is similar to income tax.
Since 401Ks and other similar investments are made into stocks and bonds they are portfolio investments, so you can even get tax advantages for your portfolio income.
The biggest benefit though is that it takes almost 0 time. If you can set it and forget it on your investments then you’re golden.
The problem with this is that it takes a lot of money invested before the amount you get back even seems worth it. For most of us it will take a 30 year career of carefully investing to have enough in our portfolio to really take notice.
There are ways to dramatically shorten that time frame, but it requires you to pay a lot more attention to your finances.
The other drawback is that investments are inherently risky. So while you can diversify your investments and so forth, there is no guarantee you’ll have as much as you think you’ll have from portfolio income when you need it.
Passive income is money that comes in whether you are working or not. This is usually based on time and effort put in up front, although sometimes money is also needed to build passive income.
The main reason that portfolio income is not the same as passive income is that portfolio income only becomes actual dollars you can use after you sell it. Passive income is money that comes into your pocket each month without selling the asset that produces it.
It does require some upfront effort, whether that is to create something, apply your knowledge purchasing assets, or just putting your money in the right spot.
True passive income is a unicorn in the investing world because it usually requires at least some effort occasionally to maintain the passive income. That’s why some people refer to it as residual income instead of passive income.
Passive income then are assets that cashflow. This can be in the form of rents or leases, royalties, dividends, or interest, etc.
- Rental properties (rent comes in monthly after buying the asset)
- Stocks that pay dividends (it is paid out to you and is separate from stock appreciation)
- Intellectual Property (you write a song/book, or create a design that sells again and again)
- Private Lending (giving money to someone who then pays you interest monthly)
The biggest benefit to passive income is that how much you make is not dependent on how much you put in. That means that the upward potential of your earnings are basically limitless.
Passive income can also have a low tax burden if done correctly. So make sure you talk to your accountant if you have passive income or plan on getting some soon to get the best tax rate you can.
Besides that it is important to note that this is the type of income that makes the wealthiest people in the world rich. Passive income is the most sought after income because of its ability to create fortunes.
The main drawback is that it is slow and takes a long time to grow. You can’t create a large amount of passive income overnight (unless you already have a lot of money). Usually it requires a huge upfront time commitment.
For example, I’ve done some publishing on Amazon (creating intellectual property) which brings in a whopping $30 a month! I know, I’m rolling in the dough.
But to get $30 a month I had to put in hours of work a week for six months. So far I’ve made very little hourly. But if my sales continue somewhat consistently over the next few years then it will pay for the time I put in many times over.
That is the gamble of the investment of time that I’m betting will pay off. It doesn’t always payoff though.
If you can’t afford to put in time upfront without getting paid that is really the only drawback to passive income. But it is well worth it.
Types of Income Conclusion
All three types of income are very important in their own way. A well rounded investor will try to use all three types of income to their advantage.
The stability of active income makes it a perfect foundation. Active income is needed to sustain day to day life and save for other types of investments. You can’t start with portfolio or passive income without active income of some kind.
Portfolio income is good for long term stability. That is why we put our retirement accounts into portfolio income. Having a long term portfolio that can grow without additional effort and that can be drawn upon in times of need makes it a perfect retirement vehicle.
Passive income is the wealth generator. While portfolio income can help build wealth, it builds it just to pull it back down (since you have to sell it). Passive income, on the other hand, can keep growing and paying for generations.
Passive income can’t be generated without the money earned from active income supporting it initially. But once you start earning passive income it can start to snowball into generational wealth.
What other types of income might there be? Do you have a unique way of earning passive income? Tell me about it in the comments below.
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A list of definitions used on this blog can be found here.
Active Income: Money earned as a direct result of putting time into work. This is for hourly, salaried, and commission based employees as well as self employed business owners who work in their business.
Portfolio Income: Money earned by investing and selling at a higher value. This includes stocks, commodities, and real estate appreciation, etc.
Passive Income: When your money or work, through investments, or royalties, or other means, continues to make money for you without any (or very little) additional effort on your part.
Asset: Things that put money into your pocket every month (or year). Sometimes equity in your house is also included as an asset, but I prefer not to include it. A car loses value every year (depreciates) so it is NOT an asset.
Cashflow: Money coming into your pocket from investing (either through stocks, real estate, or other assets). This is NOT the same as income because it doesn’t necessarily require you to work for it.
Generational Wealth: Building enough passive income that it will continue to grow and can be passed down from a parent to a child and beyond.