Did you know there is actually more than one type of income?
I had no idea until I started learning more about personal finance.
This is important because some income types are better than others.
All three types are obtained and treated differently for tax purposes.
- Related: 45 Ways To Make Extra Money
Here’s a look at the three different types of income…
1. Earned (active) income
Definition: Money earned from working that requires your time. You actively work, and you are paid for it.
Examples: Salary; wages; bonuses; contract work.
Tax implications: Earned income is taxed higher than any other income, at a rate of 10%-35%, plus Medicare, Social Security, and other taxes, which can reach close to 50% based on tax calculators and estimators.
It’s hard to become wealthy solely from earned income for two reasons. 1.) It’s taxed at the highest rate, and 2.) There are only so many hours in the day for you to work (you can work and work and work, but if you have to be there to make the money, there’s a cap on your income because time is limited).
2. Portfolio income
Definition: Money from selling an investment for more than what you paid (aka capital gains).
Examples: Stocks, bonds, mutual funds, interest, etc.; money from buying/selling real estate or other assets, such as automobiles.
Portfolio income is taxed at 10%-20% for investments held over 12 months. It’s taxed as regular earned income if held less than 12 months. However, portfolio income is not taxed for Medicare or Social Security. Capital gains can be offset by losses on other investments, which is a huge plus.
3. Passive income
Definition: Money generated from assets you own, where you are not actively working.
Examples: Rental income, business income (only if you’re not required to be there), creating/selling intellectual property.
Tax implications: Passive income receives the most favorable tax treatment. However, losses in passive income cannot be offset against other income. For real estate income, you can avoid taxation altogether through a 1031 exchange, so long as you reinvest the income into something similar (i.e., another property).
Passive income is thought to be the key to building wealth. Once you have an investment that generates recurring income, you don’t have to do much to maintain it (so time is not a limitation).
A good example of the different types of income is seen by looking at Mitt Romney’s taxes. Mitt Romney made about $21.7 million in 2010 and paid about 14% on his earnings because most of his income was from investments (capital gains). Compare this to a secretary, who could pay about 28% in taxes because her income is salaried.
A Final Note!
Understanding how income works is important because it affects your bottom line.
The three different types of income I listed above are a way of learning how to use personal finance to your advantage.
If you’re taxed at almost 50%, it’s going to take a lot more earned income for you to become wealthy than if you have passive income generated from a rental property or investments, taxed at 15%.
So, it may be smarter for you to make your money work harder for you than for you to work harder for your money.
This is the way our system works. The sooner you understand it, the sooner you can make better decisions that will help you achieve financial success.