Did you know there is actually more than one type of income?
And that it kind of matters… a lot.
I had no idea until I started learning about personal finance a few years ago.
I’m all about making more money lately, and I think one of the best things you can do for yourself is to know exactly how you want to make more money before you start. Otherwise, you’ll wander and might not like where you end up.
For example, if you value money as security, then money has the power to protect you. Money has the freedom, not you. You invest and make decisions so that you stack as much cash as possible, with the intent of retiring early and using the income from your investments to live off. This is more of the personal finance, financial independence space, that you read about on blogs, listen to on podcasts, and hear most about (the FIRE movement, if you’ve heard of it). It’s all about money as the end goal. And the way you accomplish this goal is by stacking cash.
- This is stereotypically the money management, personal finance, and financial planning advice and mindset.
On the other hand, if you make money mean that it is solely a scorecard of the value you provide to the world, then your mind is responsible for providing the security, protection, and freedom. You don’t focus on stacking as much cash as possible so you can retire because you don’t necessarily want to retire. You focus on providing value to the world as the end goal and money as the report card. You will save and hold on to money, but solely because you like money (and the having of it) not because it has power over you or can protect you.
- This is stereotypically the entrepreneur advice and mindset.
These are two very different money mindsets that lead to very different results. I have been on both sides of the table. I was a lawyer, making a high salary. Then, I was a financial planner, making a lower salary, while managing other people’s money and learning about investments. (You can read my full story here.) In both careers, I was working for someone else and receiving earned income.
Then, I became a full time blogger turned success coach and entrepreneur as I’m currently calling it, where I teach people how to make more money doing what they love. The way I receive money is different. Some is earned, some is portfolio, and some is passive.
The key is to decide what you want your life to look like with respect to work and money, then decide which type of income to use to do it.
It’s the same advice I give for everything: start from the end goal and work backward.
For example, I don’t want to retire at all, unless it’s medically necessary. I want to serve and help people as long as possible, and I think that’s my purpose on this planet. I love what I do. I want to give back. I want to provide as much value as I can while I’m alive. My goal isn’t to retire as fast as possible. If it was, I would have a completely different approach to work and money.
Assuming you’ve made your decision about what you want your end goal to be (to retire early or focus on working doing something you love forever), there are three types of income to consider going about the getting of your money.
- Side note – I’m all about saying “get money” lately because it’s the most useful way I’ve found to detach work and time from money – I also feel super gangster when I say this.
1. Earned (active) income
Definition: Earned income is money earned from working that requires your time. This is the income you receive from actively working. You work and you are paid for your work.
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.
Characteristics: It’s hard to become wealthy solely from earned income for a few reasons. First, it’s taxed at the highest rate, and second, 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).
Another downside besides taxes is that once you stop working, the money stops coming in.
On the upside, earned income is the easiest type of income to make. You can just go get a job or side job pretty easily in the US and make some money. This is why most people make money this way–it’s easy to do.
A great way to switch over into better types of income is to use earned income by putting it into a portfolio or to start a side hustle or business (this is what I did by starting a blog, which is now my full time business).
2. Portfolio income
Definition: Portfolio income is money you receive from selling an investment for more than what you paid for it (portfolio income is also referred to as capital gains).
Examples: 1) trading assets, like stocks, bonds, and mutual funds, 2) buy and selling real estate, and 3) buying and selling other assets, like a car.
Tax implications: Portfolio income is taxed at 10%-20% for investments held over 12 months and taxed as 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.
Characteristics: One downside is that for the average person, investing can seem intimidating. This often keeps people away from doing it. It wasn’t until I became a Certified Financial Planner that I really understood what was going on with respect to portfolio income.
If you’re just getting started with investing, read this post – 21 tips for investing in your 30’s.
Also, this type of income can take a long time to generate if you believe in many of the widely held investing concepts that require buying and holding for years. If you’re a trader and attempt to do it much faster, you better be really good at it, because otherwise, it’s sort of like gambling.
You have to have money to invest upfront to create portfolio income. This is a huge reason why people say they don’t invest. You can start with a small amount and contribute to your investments over time, but it requires you to have the capital to do it.
If you want to get started with hiring someone to help you with your money, read this post on questions you should ask your financial advisor before hiring her.
I like using investing as a supplemental income strategy. I don’t want to retire, but I like the idea that I could if I ever change my mind or it became medically necessary. So, I save and invest as a bit of a safety net, but not as the end goal of retiring as soon as possible. I like contributing to the world through my work, and I also like creating a lot of income. I just don’t ever tie my “hard work” or time to income generated. This way, I know my income potential is unlimited.
3. Passive income
Definition: Passive income is money generated from assets you own, where you are not actively working.
Examples: Rental income, business income (as long as it’s not earned based on time and effort), creating/selling intellectual property (e.g.: books).
Tax implications: Passive income receives the most favorable tax treatment.
Characteristics: 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).
Typically, there isn’t much start up cost to passive income that you have to provide yourself. For example, you can use your time to create a business or you can get funding from investors for your real estate properties or start up company. It’s not as easy as earned income, but it’s not as challenging as portfolio income (in terms of start up funds). It takes a lot of money to make a lot of portfolio income, whereas you can generate a lot of passive income with less.
I started a blog with the idea of generating passive income (the Smart Passive Income podcast used to be on repeat!). It’s one of the best things I ever did!
A Final Note!
Understanding how income works is important because it affects how you go about deciding what results you want with money in your future.
Do you want to retire? Do you want financial independence early?
Do you want to focus on contributing to the world through your work as an entrepreneur? Do you want money just to be a scorecard of the value you provide?
Do you believe that “hard work” and time create money?
(So many questions!)
These are philosophical questions, but whatever you believe will drive your feelings, which will drive your actions, which will drive your results. So, ultimately, your beliefs drive your results (you can read more about this in the 5 step framework to master your mindset post here).
Based on what you choose to believe, you could end up financial independent and retiring very young and living off 4% of your investment portfolio, with frugal values, while traveling, and doing whatever else you want to experience the world while you’re alive. Or, you could end up a multimillionaire focusing on serving the world through your work and never retiring. Completely different results. Both involve a lot of money.
What you choose matters. What you believe about money matters. What you do matters.
The three different types of income are a way of learning how to use money to your advantage to get the results you want most.
This is the way our system works. The sooner you understand how money works, the sooner you can make better decisions that will help you achieve financial success (whatever that looks like to you).