Getting your finances in order doesn't have to be overwhelming. Learn more about the main types of income.
There are three main types of income: active, passive, and portfolio income. Each has slightly different definitions and tax rates.
Learn more about these types of income, including the most common examples of each and what other income types you may come across.
Different Types Of Income – What To Know
When planning your financial future, you have to consider your income. But you can't consider it without fully understanding your income.
Most financial experts agree that there are three main types of income. While you will hear of other income types, each of those can fall into one of the three main categories.
What Does Income Mean
Before exploring the types of income, it is important to understand what income is. It refers to the money that you (as a person or business) earn in exchange for investing capital, producing a service or goods, or providing labor.
Most people will earn their income via a salary or wages. Most businesses earn their income from selling services or goods.
No matter where you live, your income is likely to be taxed.
Do You Need To Know The Types Of Income?
Simply knowing that income is money you earn in some way may seem like enough information for the average person. But the reality is that the better you understand income, the more equipped you will be to make financial decisions.
Understanding the types lets you diversify your income sources, so you always have at least one source of income. Or it can simply help you create strategies.
Understanding your income is crucial for creating and achieving any goals.
Take retirement, for example. You will need to understand your current income streams and how each one is taxed to figure out how much you can save for retirement.
Moreover, you will have to understand the same things about the income sources during retirement. You likely won't have active income, but you may have passive or portfolio income. Knowing this can help you figure out how much you will need to save.
3 Types of Income
There are three main categories of income, and any other type of income that you come across should fit into one of these categories.
We will also touch on the advantages and disadvantages of each income type. Remember that for most people, the best strategy is to diversify your income and have all three types.
Active Income (Earned Income)
Active income is the type of income that likely comes to mind right away. The most common example is the salary or wages you earn from your job. It can also include commissions and tips.
In simple terms, active income is the income you have to put active effort into earning. It is what most people earn at their jobs.
The most common examples include:
- Your salaried job
- The hourly wage at your job
- Freelancing or consulting income
You also receive it regularly, at least in most cases. Tips and commissions can be more irregular.
To increase this type of income, you may have to work more hours. Alternatively, you can look for a job with the same hours that pays a higher wage or salary.
Active income is the most attainable type of income for those early in their career. Finding any regular job will be enough to let you earn an active income. This is possible regardless of your skills or sector.
Yes, job hunting comes with a lot of challenges. However, you don't need to invest money upfront, other than transportation for the interview and work-appropriate clothing.
This type of income is also considered to be less risky. After all, you will always earn it based on your job contract; you can't lose money as you may with portfolio income.
The biggest disadvantage of active income is that you have to put in time and effort to earn it.
It also tends to have the highest tax rate.
The other issue is that you are entirely dependent on your job. If you lose your job, you lose your income.
There is also the fact that you may not like your job. Maybe you dislike it or dislike the company. Or perhaps you don't feel like you are valued as an employee.
Passive income is easily the most useful type of income, as it doesn't require any active effort on your part.
You earn passive income if you do not need to be actively involved. You may have originally put in the effort, but you no longer have to. In fact, nearly all passive income sources will require an initial investment of time and money. At some point, however, you can sit back and relax and earn money.
This means that the amount of passive income you earn is not directly related to the number of hours you work, like what active income frequently is. Instead, it is related to the number of revenue streams you have.
The following are some of the most common examples of passive income:
- Royalties from book sales
- Renting properties
- Renting equipment
- Affiliate marketing
- Being a part-owner of a company that essentially runs itself
- Buying a website or blog
- Selling independent merchandise from your website or blog
- Crowdfunding investments
- Real estate investment trusts
The biggest advantage of passive income is that you don't have to use your time to earn it after you initially set it up. With passive income, you can earn money while sleeping or on vacation.
Many passive income sources also give you some level of control over the income's future performance. For example, you can choose where to buy investment properties that you rent out based on market predictions.
This type of income is also typically taxed at a lower rate.
Before you can earn passive income, you will have to put in a lot of time and effort, along with money in most cases.
There is also no guarantee that your efforts to create passive income will be successful.
Portfolio income refers to the income that you gain from investments. It includes capital gains, interest, dividends, and royalties.
You do not necessarily receive portfolio income on a regular schedule. This may be the case with some types, such as dividends. However, you only receive the income from many portfolio investments when you sell the asset.
The most common example of portfolio income is trading stocks. If you buy the stocks when they are low and sell them when they are high, this is portfolio income.
The following are just some of the most common portfolio income sources:
- Trading stocks
- Opening a savings account with a high-interest rate
- Becoming a company shareholder
- Buying smaller quantities of stocks from many companies
- Buying dividend ETFs (exchange-traded funds)
- Investing in P2P (peer-to-peer) loans
- Buying and selling collectibles
Compared to the other types of income, portfolio income doesn't usually require as much effort. Your most important task is to buy and sell at the right time.
This type of income also tends to be tax optimized.
Saying that you have to buy and sell at the right time is much easier said than done. You need a lot of knowledge to grow your portfolio income. That either requires time from you to learn it or paying someone to manage the assets for you.
You also don't have a lot of control over the assets. Your only control is the ability to buy or sell.
You also typically need a large upfront investment.
How People Typically Expand Between Types of Income
Most people will start their adult lives by earning just active income. Then they will start to save up enough money to invest in other income sources.
At this point, they can look for a portfolio or passive income. Either income typically requires an upfront investment of time and money. Early on in their careers, most people don't have enough disposable income to make that investment yet.
The key to being able to invest in passive or portfolio income is living within your means. Most importantly, as your active income increases, try not to change your lifestyle. Instead of using the extra active income to improve your lifestyle or splurge on luxuries, you can invest it to increase your passive or portfolio income.
The Types of Income and Taxes
No matter where you live, your government is likely to tax each category of income slightly differently.
Your active income is typically the bulk of your taxes. Your income tax rate will depend on your total income for that year, with people who earn more having higher tax rates. Importantly, the United States and most other countries use tax brackets. Only a portion of your earnings above a certain amount will be taxed at a higher rate.
Your portfolio income is the other major contribution to your taxes, but it is taxed at a lower rate, at least in most cases. Your portfolio income tax rate also depends on your total income. It is also worth noting that you pay higher taxes on short-term capital gains from your portfolio than you do on long-term ones.
It becomes a bit more complicated for passive income. Depending on the type and length of time of your passive income, your tax rate may vary.
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The three main types of income are passive, active, and portfolio income. Each has its advantages, but the best strategy is to combine all three. Having a combination of income sources will protect your financial future.
Also read: Residual Income Definition
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.