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3 Types of Income Overview
It’s important to understand the different types of income that you can generate if you want to make and achieve your financial goals.
Not only it’s a good thing to understand the different types of income that you can earn to build wealth but it’s also important for you to understand “income” if you are going to play the money game in the big leagues!
Before we begin diving into the “3 types of income”, let’s define what is income in the first place?
Income is a term used to refer to money that you and I can make (or a business can make) by providing labor, services, producing goods, or investing.
Typically, an individual will earn his or her income by working on a job and getting a salary, wages, commissions, tips, bonus, or something similar.
Businesses will generally earn an income by selling goods and services to their clients or investing their capital into various investment assets.
In essence, there are three main ways that you and I can earn an income: earned income (or active income), portfolio income, and passive income.
Earned income is what you make by working on a job, such as your wages, salary, bonus, or commission.
Portfolio income is a type of income that you earn when you make a profit by selling an investment asset.
Passive income is the third type of income that you can earn passively and without your material participation in the income generation process.
What Are The 3 Types of Income
Let’s break down the three types of income so we can better understand earned income, portfolio income, and passive income.
The first type of income out of the three that you can earn is earned income, also known as active income.
In the United States, money that you make as a result of your labor by working for someone is earned income.
Typically, this income is reported on your W-2 or if it’s a small business income, on your Form 1040.
The second income type out of the 3 is referred to as “portfolio income”.
You make a portfolio income by selling an asset above the price that you originally paid for it.
If you have gained, or a profit, by selling an investment asset, you earn a portfolio income.
This type of income is generally subject to the capital gains tax.
Money that you earn from your investments such as dividends and interest payments are also considered portfolio income.
The third type of income is passive income.
This is a type of income that you can continue generating without much participation or effort on your part.
Passive income can include things like rental income, royalties earned on your creations or software, income from a business or investment partnership in which you are a passive investor, and so on.
For example, if you purchase a real estate property and rent it out, the income you generate is passive (even though you may have to make some effort in maintaining the property and dealing with your tenant.
As a subset of passive income, you also have “non-passive income”.
A non-passive income is something between earned income and passive income for tax purposes.
For example, if you own an S Corporation where you generate business income and flow it through to the shareholders, the income will be reported as non-passive income (K-1 form) if you were materially participating to generate the income.
Otherwise, if you received income flown down to you from an S-Corporation without your material participation, then you’ll have passive income.
Pros And Cons of The Three Income Types
What are the pros and cons of the three types of income?
Let’s break it down!
Earned Income Pros And Cons
The main advantage of making earned income or money from employment is that you can count on the money coming in steadily.
In other words, you know you have so much money coming in from your salary and so you can plan your expenses and spendings accordingly.
If you work hard, with time you can get promoted and earn more money.
The disadvantage is that you need to trade your time for money.
In other words, the more time you put in, the more you can make money.
However, time is a limited commodity and sometimes you are not going to get compensated adequately for the time you are putting in.
Also, you don’t have much control over your life as you need to work hard to ensure that your boss is happy so you can keep your job.
If you don’t make enough money, then you’ll have a hard time achieving your financial goals or eventually becoming financially free.
Portfolio Income Pros And Cons
Portfolio income is perhaps the category that has the potential of making a lof people really rich.
If you make investments and your money starts generating money for you, you are on your way to building your net equity and wealth.
Many entrepreneurs and people we consider successful in life have significant amounts of money coming in from their investments.
For that reason, they are not using their time to earn money.
As a result, they can spend their actual time on leisure while they continue earning massive amounts of money.
The downside to portfolio income is that you need to have the money to be able to invest it.
For many, having the right amount of capital to start investing is the main drawback preventing them from earning investment returns.
Another drawback is that you’ll need to pay taxes on the money that you earn.
If you don’t plan your investments properly, you’ll end up paying more taxes than expected cutting into your profit margin or overall profitability.
Passive Income Pros And Cons
Passive income, as the name suggests, is earned passively.
Earning passive money is like music to my ears.
I specialize in earning income passively so I can spend a lot of time talking about this topic.
The main advantage of earning passive income is that you are able to make money without actively participating or putting in a lot of effort to keep the money coming in.
This means that you can become financially free, earn money while you travel, or free up your time to do what you love.
The second most notable advantage is that you can create multiple streams of passive income for yourself allowing you to significantly scale the amount of money that you can potentially earn.
The main drawback is that there is no such thing as making money without putting in the hard work or money.
To earn passive income, you still need to create something or invest in something that can generate passive income for you.
If you don’t have the money to invest in passive income investments, then you are not going to fully take advantage of this.
Also, if you don’t spend time and put in the effort to create something that will eventually offer you passive income, you will also not make it in this category.
3 Income Type Examples
In practical terms, what are different examples of income that can be earned either actively, passively, or through investments?
Let’s look at the most common types of income in each of our three income categories to illustrate the concept better.
Earned Income Examples
Here are some examples of active income by someone working as an employee for another:
- Waiter or waitress
- Office clerk
- Office manager
- Store supervisor
- Web designer
- Content marketer
- Company accountant
- Sales representative
- Customer service representative
- Graphic designer
- Construction worker
- Marketing manager
- Working as a freelancer
- Hourly employee
- Company consultant
As you can see, the common thread here is that the examples in this list refer to jobs that someone can hold working as an employee for a company.
Portfolio Income Examples
Here is a list of portfolio income that you can earn through your investments:
- Dividend income buying stocks
- Interest income by putting money in certificates of deposit
- Interest income by investing in bonds
- Buying shares of stock and selling it above the purchase price
- Putting your money in a savings account
- Peer-to-peer (P2P) lending
- Purchasing dividend exchange-traded funds (ETFs)
- Creating music and earning royalties
- Creating videos and earning royalties
- Becoming a silent partner in a small business
The common thread in the above examples is that you are either earning a return (or cash flow) coming from your investment or you are earning a profit by buying and selling an investment instrument (or asset).
Passive Income Examples
Here is a list of passive income that you can earn without your material participation in keeping the cash flow from coming in:
- Earning advertising income by starting a blog
- Receiving royalties from the sale of e-books online
- Earning commissions through online affiliate marketing
- Receiving advertising revenues from making YouTube videos
- Making money from digital downloads
- Earning income by selling online courses
- Purchasing real estate property to get rental income
- Purchasing tools and equipment to get rental income
- Buying a blog earning advertising income
- Dropshipping on e-commerce sites
The common thread for all the passive income examples is that they typically require time to set up but when the income starts flowing in, maintaining the income is more passive or will not require as much effort to continue getting.
How Taxes Affect The 3 Types of Income
As you know, there are two things that are certain: death and taxes!
No matter which income you earn out of the 3 categories we discussed, you will need to pay taxes.
The type of income, how much income was derived, and in what way will have an impact on your tax rate and ultimately how much taxes you must pay.
It is crucial that you understand the basic tax consequences of the three types of income so you can plan your financial decisions in a thoughtful and strategic way.
Taxes on Active Income
Active income or earned income is typically taxed based on how much money you earned in a given year.
Generally, the higher your salary or wages, the more taxes you’ll pay.
For example, a person earning a lower salary will be in a lower tax bracket than a higher-income taxpayer.
Taxes on Portfolio Income
When you buy and sell investments for a profit, you will have to pay taxes.
Typically, dividend income, interest income, and capital gains are taxed at a lower rate than earned income and not subject to Social Security or Medicare taxes.
Depending on how much profit you made (capital gains), the actual amount of taxes you’ll need to pay may vary.
Taxes on Passive Income
Passive income is also taxed just like earned income and portfolio income.
If you earn passive income, you will also need to report that on your taxes.
The rules can get a bit complicated depending on what is qualified as passive income and what is not.
Generally, if you make rental income, that’s considered passive income and will be taxed as such.
Also, if you are earning money from a business in which you do not materially participate in, that could also be passive income.
3 Income Types Takeaways
What are the 3 most common types of income?
What are the 3 types of income?
In this article, I’ve looked at the different types of income that you can make so you can better understand the concept.
There are different ways we can make money.
Each of the 3 types of income has its benefits and drawbacks depending on your situation.
What’s important is that you know the 3 incomes, understand how you can earn them, assess whether or not you can make money that way, and how this would fit into your overall financial plan.
Why You Should Join My Passive Income Blog
It’s been great having you on my blog.
Just so you know a little about me!
On this blog, I focus on generating passive income in order to build wealth over time.
Over the years, I have built a portfolio of passive income sources generating me a constant, continuous, and reliable source of cash flow every month (it is awesome!!).
I made a lot of mistakes on the way and learned a lot.
Now, my mission is to teach you my secrets, guide you, and show you how to make passive income for yourself.
I don’t offer a get-rick-fast scheme or I will not make you a millionaire overnight.
However, what I can do is to provide you real and actionable strategies that you (anyone) can implement on any scale (large or small) to make money passively.
If you are willing to dedicate yourself, work hard, and make sacrifices, I can help you change your life around.
I only focus on tried and true methods for making money and they take time, patience, perseverance, and a lot of hard work.
When you sign up, I will share with you my exclusive content on passive income, tell you about the tools I use, strategies that I’ve used, what successful entrepreneurs do to make piles of money, and most importantly my actionable tips to get you started!
Are you ready to live life on your own terms?
Can you make the commitment today?
If you are ready and willing to commit yourself, come with me and let’s go on a wonderful journey together…
With that being said, let’s head right back to our main topic!
3 Types of Income
If you enjoyed this article on 3 Types of Income, I recommend you look at our blog to learn about ways you can make money and achieve financial freedom. Enjoy!
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