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Unfortunately, money doesn’t grow on trees. Though I sure wish they did.
Many people are familiar with working for money during their 9-to-5 day jobs. It’s the most common type of income and the only type that schools teach about.
But did you know that there are three different types of income?
If you want to become more financially literate, understanding the differences between the three types of income is key. Not only will you be able to make better money decisions, but you’ll also be able to diversify your income streams.
Are you ready to improve your financial literacy? Let’s dive right in.
What are the 3 types of income?
The three types of income you should know about are earned income, portfolio income, and passive income. They’re all equally important but the main difference is how the money is made.
Earned Income
The first type of income I want to go over is earned income. It’s the most common type of income that almost everyone relies on.
Earned income, otherwise known as active income, involves directly exchanging your time for money. This can include money earned from a 9 to 5 day job, tips, commissions, and wages.
If you work for a company, you may be paid an hourly wage or a salary. An hourly wage is paid based on how much time you work, and a salary is a fixed amount of money that’s paid to do a certain job.
Have you ever mowed the lawn, delivered newspapers, or did chores in exchange for allowance when you were a child? Those are all examples of earned income.
Although earned income is the most heavily relied upon, it’s also taxed the heaviest. Tax percentages can range anywhere from 10% to 37%.
Furthermore, there’s a cap on how much money you can earn from earned income. You only have 24 hours in a day and there’s only one of you. The only two ways you can increase how much you earn is by getting paid a higher wage, or by working more hours.
Wages can significantly differ depending on your education and experience. The federal minimum wage in the U.S. is $7.25, although 30 states have a minimum wage higher than the federal level. The highest-paying jobs out there are doctors, which generally make around $200,000 a year.
Portfolio Income
Portfolio income is categorized as any type of income you earn from your investments. This can include interest, dividends, and capital gains.
You can earn interest from savings accounts, checking accounts, money market accounts, certificates of deposit, and bonds. These products are usually issued by banks and the banks will pay you interest for you to hold your money with them.
Interest rates on these products vary, but most of them are pretty low. For example, the interest rate for the average savings account in the U.S. is around 0.19%, and around 1% for an average certificate of deposit.
Bonds are issued by companies to raise funds for an upcoming project. For example, if Apple needed to raise funds for their new iPhone, they would issue bonds. By investing in a bond, you lend Apple your money for a certain period in exchange for interest.
Bonds yield a bit higher than bank accounts and CDs. If we take a look at Vanguard’s Total Bond Market ETF, we can see that it has historically yielded around 2-3%, which gives us a rough estimate of the average bond yield. Some bonds yield higher but those are high risk and are referred to as “junk bonds.”
Dividends are usually earned from stocks. Companies issue dividends to their shareholders in a way to thank the shareholders for investing in the company.
Some companies opt to not issue dividends and instead reinvest the money back into the company so it can grow at a faster rate. Other companies like AT&T and Verizon pay dividends of up to 7%.
Portfolio income is taxed at a lower rate depending on how long you hold the investments. The longer you hold them, the less you’re taxed.
Income from paper assets such as stocks can be largely divided into two categories: short-term capital gains and long-term capital gains. While short-term capital gains are taxed at your ordinary earned income tax bracket, long-term capital gains are taxed at either 0%, 15%, or 20%. However, you’re going to need to hold the investments for longer than one year for them to qualify as long-term.
Passive Income
Have you ever wanted to earn income in your sleep? That’s exactly what passive income is.
Passive income involves earning income from something you own but don’t sell. It doesn’t require you to exchange your time or to be actively involved which is why it’s called “passive.”
Many people think passive income is receiving money for doing absolutely nothing. That’s unfortunately not the case. The process of setting up passive income is long and tedious and requires lots of studying. Needless to say, the payoff in the end can be great, as you won’t have to actively work for money.
Rental income is a form of passive income. You own the property, lend it out to others, and collect monthly rent in return. Buying rental properties is no easy task and requires a lot of upfront work before making the purchase. However, they can pay off big time in the end if done properly.
Also, rental properties can be truly passive if you hire a property manager. The property remains yours, but the manager will attend to all the tenants’ needs.
Another example of passive income is receiving royalties on things you made. If you’ve ever invented something or written a song, you can let other people use it and receive royalties in exchange. Royalty rates range anywhere from 2-15%, depending on the demand of the property.
Unlike earned income, passive income does not come with a cap on how much you can earn. Because passive income does not require you to exchange money for your time, you can theoretically earn an infinite amount of money.
Just like portfolio income, passive income is also more tax-efficient compared to earned income. Investments like real estate also come with many tax write-off opportunities.
How do you make all three sources of income?
To build wealth and to be financially well-off, it’s important you diversify the types of income you receive and not only rely on one source. Even the famous Warren Buffett once said, “Never depend on a single income. Make investments to create a second.”
The majority of people only rely on earned income as their only source. The problem with that is if you were to lose your job, you would lose your only source of income.
Let’s take a look at how you can create additional sources of income.
Get A Job
Getting a job is going to be the first step you take. You probably already have one, but if not, you’re going to need to get one.
Everyone must start by trading their time for money. It doesn’t sound appealing, but you have to start making money from somewhere. Earned income is the only type of income that pays off immediately, and bills need to be paid.
Spend Less Than You Earn
If you make $50,000 a year and manage to save $5,000, you are richer than the person who makes $100,000 and spends it all.
Learn how to spend less than you earn. It doesn’t matter how much you make if none of it stays with you.
Do you need help saving money? Here are 11 unique tips that will boost your savings.
Invest Your Leftover Money
Now that you’re saving money at the end of each month, you want to start investing some of it. Investments can be anything you want; the key is to just get started because the earlier you start, the better off you’ll be.
Here at InvestaMind, I teach how to invest in the stock market. The 3-Fund Portfolio is a great way to get started investing in the stock market. It’s the easiest and most passive way to build generational wealth without taking on too much risk.
Your investment strategy doesn’t have to be the 3-Fund Portfolio. But the important thing you should do is create a plan and stick with it no matter what the market does.
Remember that investing in the stock market is a long-term game. Although you won’t be able to reap the benefits immediately, you’ll build wealth by sticking to your plan for the long term.
Investments will also provide you with capital once you retire and stop trading your time for earned income.
Start a Side Hustle
Starting a side hustle is what will allow you to build passive income. This is probably the hardest type of income to earn out of the three, but it’ll pay off big time in the future once it takes off.
These days with the internet, there are so many ways to start a side hustle with very little money. It’s going to take some time to learn how to start, but it’s achievable if you set your mind to it.
Do you have a passion, hobby, or something you feel strongly about? Consider teaching others with similar interests by writing an e-book or creating an online course.
If you’re into videography, you can start a YouTube channel, and if you’re into fashion, you can start a clothing brand line.
The sky is the limit.
Just like portfolio income, you won’t be able to immediately profit from building a side hustle. It takes time and consistency to build. But once you get the ball rolling, you’ll be on your way to building passive income. Just remember to be consistent and trust the process.
Conclusion
The three types of income we went over today are earned income, portfolio income, and passive income.
Earned income is income you earn by exchanging your time for money. Portfolio income is earned from your investments, and passive income is earned from things that you own that generate money.
How many streams of income do you have?