When it comes to building wealth, it’s essential to understand how you can go about doing it. Becoming wealthy doesn’t have to come from getting a big paycheck.
People of all income levels can become millionaires. For starters, have a budget and always be living below your means. After that, you’ll need to understand you need to diversify your income, not just your investment portfolio.
In this post, we'll explore the three main types of income, the benefits and drawbacks of each type of income, and why you should build each type of income. Let's get started!
What are the Types of Income?
There are three common types of income you can make. We'll explore them below!
When using the word income, most of us will think of our 9-5 job. Income from your job is known as active or earned income. You perform a service or duty for a company. They, in turn, will pay you for those services. You can have a high-paying profession like a doctor or lawyer. You could also have a lower-paying job like a cashier. Maybe you make your living by having a skill like plumbing or being an electrician. No matter what you do or who you work for, you are earning an active income. For most of us, this is the primary source of our income and is our first step when it comes to building wealth.
Active Income Upside
Typically, having a regular job with a steady income is the fastest way to build wealth. Out of the three types of income, it will usually be the most significant amount of money you are earning. Although not always the case, active income will generally be the easiest and fastest to increase as well. Active income will be your primary income source, providing you the money you need to live and cover everyday expenses. Eventually, the goal should be to build up other income sources. Building up other forms of income will allow you to be able to get yourself away from a full-time job or pursue a passion you can get paid for too.
Active Income Downside
There are two sides to every coin. Everyone should have a form of active income, but there are a few downsides to it. Number one, earning an active income takes up most of your time, a finite resource for us mere mortals. It can take decades to build up enough of the other two types of income to get to a point where you can ditch active income or at least do it on your terms. Earned income is also taxed at the highest rate of the three.
The second form of income is called passive income. Passive income is money you earn from any assets you might have. There are tons of ways to earn passive income. You can create passive income from stock dividends, rent money from investment properties you may own, royalties, or even a blog you might run, among other things. There might be some initial upfront or setup work. Still, if you are earning money from an asset while doing next to nothing or, as they say, “making money in your sleep,” then you are earning passive income. Passive income is the type of income most of us strive for. However, it can be the hardest to build up. With enough passive income, you can achieve your goal of financial independence.
Related: How to Make Your Money Work For You
Passive Income Upside
Clearly, the biggest perk of passive income is that, unlike active income, it doesn’t take up much of your time. You might have to put in some up-front work, but after that, you can sit back and earn money without doing much and using your time to create even more income.
Passive Income Downside
There are two main downsides to passive income. For one, you need some initial capital built up to obtain the necessary assets to create passive income. Basically, you’ll need money to make money. The amount for different types of investments varies. Still, the bottom line is that you’ll need something extra from your active income to invest.
The other downside is that creating large amounts of passive income takes a long time. Dividends, rents, royalties all pay small percentages of the initial investment. It can take years to make back an initial investment. You’ll also need several passive income sources to reach an amount substantial enough for achieving financial independence.
Portfolio Income (Capital Gains)
The third and last form of income is known as portfolio income or more commonly known as capital gains. Portfolio income is any money you’d make from selling assets like stocks, mutual funds, index funds, or any other investments you may have. For example, if you bought ten shares of company stock at $100, it doubled to $200, and you sold it. You would have made $1000. The $1000 would be considered portfolio income. If you purchased an investment property for 100k, then turned around and sold it for 120k, you’d have a 20k in capital gains(minus those pesky realtor fees, of course!).
Portfolio Income Upside
The upside to portfolio income is similar to that of passive income, with a little bit of an added bonus. Like passive income, portfolio income can take up little to none of your time if you want it to. For stocks, mutual funds, and other stock market investments, it can basically be the time it takes you to do any investment research and selling. For some, that can be more, but the time commitment will be very low for those of us with simple investment strategies.
Another advantage capital gains have is that they are taxed differently from active income. The good news is that it’s typically at a lower rate. Capital gains will be taxed at the same rate as active income if you are in a lower tax bracket. Even for those in the higher tax brackets, capital gains cap at a 20% tax rate. The tax rate can vary, though, based on the duration of the investment. If the investment is long-term, they will only be taxed at a 15% rate. Typically, to be considered a long-term investment, at least tax-wise, stock or other investments will need to be held for at least a full year. Both of these rates could be significantly lower than the rate at which you pay for active income.
Portfolio Income Downside
The downside to portfolio income is similar to that of passive income. To create portfolio income, you’ll need to have money set aside as an initial investment. It could also take, scratch that, it will take a long time to reach a sizable amount of portfolio income.
On top of these similarities, there is one last downside to portfolio gains. When investing, you don’t always make money. If you make risker investments, you could end up losing a significant amount or all of your money. There is also the fear or panic factor to deal with. If you are not thinking long-term, it’s all too easy to see a significant market drop and sell out of fear of losing even more money. Given enough time, the market will come back and continuously reach new highs, making selling at the wrong time even that more painful. Fear not, though, as there are plenty of safe ways to invest your money long term that will make you wealthy.
Why You Should Have All Three Types of Income
Each form of income has its advantages and disadvantages. Still, it’s a good idea to have all three in your arsenal. The best way to build wealth is to have multiple income sources and different types of income as well. By having multiple sources and types of income, not only are you increasing your assets and buying power, but you’re also protecting yourself. If one income source isn’t doing as well for whatever reason, you’ll have others to pick up the slack. If you rely solely on one source of income and that takes a hit or is completely gone, you’ll have nothing to fall back on. By having all three sources of income, you’ll be building a stable financial foundation.
Final Thoughts on Types of Income
There are countless ways to earn income, but only so much time in our day.
The easiest and fastest way to make money is having an active income stream, trading your time for money. However, adding the passive and portfolio income into the mix is a great way to build wealth and protect yourself from any unforeseen events.
Hopefully, with enough passive and portfolio income, you’ll be able to switch your active income to a job that you are passionate about or be able to take yourself out of the rat race for good.