Growing up you’re told that some day you will get a job, make money, retire and live happily ever after.
The reality that most of us are sold is that the only way to earn money is by giving time to someone in exchange for income. Whether that’s through a job as a plumber, doctor, teacher, or whatever, we’re taught that earnings come from going to work and bringing home a paycheck.
It wasn’t until I got older and did some reading that I realized this was only partially true. In fact, there are many people making money while they sleep.
In reality, there are three types of income: earned income, portfolio income, and passive income.
Having an understanding of these three types of income is important to building wealth. Each type is different with their own sets of advantages and disadvantages.
Before you can create a plan to start bringing more money into your life you must understand how these three types of income work.
This article outlines the three types of income, examples of each, and their advantages and disadvantages.
Let’s jump in.
1. Earned Income
Earned income is money that is received from working for someone else. It is the most common form of income. You provide your time, do a job, and in return you receive a paycheck.
Earned income most commonly refers to wages and salaries but it also includes any bonuses, commissions, tips, or earnings from self-employment.
Examples of Earned Income
Any type of 9-5 job is an example of earned income. If you go to a job in the morning and come back in the afternoon, you are receiving earned income. (Unless you’re doing that job for free, in which case you must already have a lot of money, or, you’re simply getting screwed.)
You can receive earned income from so many types of jobs:
- Gig worker (hourly pay plus tips)
- Salaried worker (base pay plus bonuses)
- Sales agent (base pay plus commissions)
In each of these cases the person is trading their time and services for money.
Advantages of Earned Income
A big pro is consistency. You can reliably count on money coming in each day, week, or month. As long as you are showing up and doing your job at an acceptable level, you will get paid. This type of steady of income is important when you have bills to pay and a family to feed.
Another pro is that you can work hard for more money. For many jobs if you work hard and provide more value to the company or organization, consequently you will get paid more. Yes, you may need to work more hours or learn new skills in the process, but for many more money for more work is worth it.
As a teacher, our salary is based off a pay scale that is measured through years of service and level of education. So I work hard for more money by taking graduate classes and side hustling after school. I teach private music lessons and most recently joined the gig economy using instacart.
Disadvantages of Earned Income
The biggest downside of earned income is that you must trade your time for money. Whether it is time that you spend building a business or time clocking in and clocking out each day, you’re trading time for money. Since time is arguably the most valuable asset that humans can have, giving it away for more money better be worth it.
Another downside is that earned income is taxed higher than other types of income. The tax rate that you pay differs depending on how much you earn. In 2020, this ranges from 10% for your first $9,875 as a single ($19,750 married filling jointly), all the way up to 37% for income earned over $518,400 as a single (over $622,050 married filling jointly).
2. Portfolio Income
Portfolio income, or capital gains income, is money that is gained from selling an investment for a higher price than you bought it for. Although there are many different types of investments that can generate portfolio income, the most common example is investing in financial assets.
Examples of Portfolio Income
To understand how it works, let’s say that you buy a stock, such as Apple, for $100. Then by next year that stock goes up 50% and you sell. You just made yourself $50 in portfolio income.
But do you have to sell your stocks in order to receive portfolio income?
Actually, no. Many stocks pay dividends (a type of portfolio income) to their investors. These are payments made by companies to shareholders for owning their particular stock. You do not need to sell your stocks in order to receive dividend payments.
Advantages of Portfolio Income
For the most part, portfolio income does not require a lot of time to set up. The amount of time you spend will depend on what type of investing you do. For example, an index fund investor will basically set their investment and forget it. They will gain an average 7-10% return year after year with little to no work. Whereas an active stock trader spends a lot more time buying and selling.
Another benefit is that portfolio income is taxed more favorably than earned income. When you buy and sell a financial asset for a profit you trigger a taxable event. If this happens within a year or less, your gains are taxed as ordinary income. When you hold an asset for over a year though, the rates you will pay on capital gains are 0%, 15%, or 20%, depending on your tax bracket. This is much better than the rates on earned income.
Refer to this chart from Investopedia on the tax rates for long-term capital gains.
| Tax Rates for Long-Term Capital Gains | |||
|---|---|---|---|
| Filing Status | 0% | 15% | 20% |
| Single | Up to $40,000 | $40,001 to $441,450 | Over $441,450 |
| Head of household | Up to $53,600 | $53,601 to $469,050 | Over $469,050 |
| Married filing jointly and surviving spouse | Up to $80,000 | $80,001 to $496,600 | Over $496,600 |
| Married filing separately | Up to $40,000 | $40,001 to $248,300 | Over $248,300 |
Disadvantages of Portfolio Income
Unlike earned income, portfolio income requires that you have money to invest to get started. This can take time saving up the amount of money needed to start investing. The amount that you need will depend on the type of investment. For example – investing $20 in a stock vs. an index fund with a minimum $3k deposit.
3. Passive Income
Passive Income is a type of income that is earned through little to no daily effort. It’s the returns from your money working for you rather than you working for your money.
Investopedia defines passive income as,
“…earnings derived from a rental property, limited partnership, or other enterprise in which a person is not actively involved.”
It’s important to note that even though passive income means you make money with little to no work, this doesn’t mean that there is no upfront time and effort. In many cases, you will need to put in a significant amount of time, energy, and money early on before you get to a point where you make money passively.
Examples of Passive Income
There are a multitude of ways to earn passive income.
Some examples include:
- Affiliate Marketing
- Owning Rental Properties
- Owning businesses that don’t require active participation
- Peer-to-peer lending
- Creating an app
- Creating an online course
- Having money in a high yield savings account
- Advertising on your car
Two of the most common though are owning rental properties and creating online courses.
Rental Properties
Owning and renting out properties can be a powerful way to make passive income. You can rent to longterm tenants or choose to use a short term rental service like Airbnb. When you have multiple rental units and really want to be hands off, you might consider hiring a property manager. This way you don’t have to get too involved when there is a plumbing problem or the heat stops working.
Before becoming a rental property owner, make sure you do your research. Understanding your upfront costs and potential cashflow will be important calculations to consider before jumping in.
Creating Online Courses
If you have an expertise in a particular area and you’re half decent at breaking down and explaining information, then you may consider creating an online course. Platforms like Teachable and Udemy allow you to create and sell courses seamlessly.
As with many passive income opportunities, there is a lot of upfront time and effort that goes into creating an online course. Plus, it can sometimes take more than a year to build up an audience of potential buyers. If you put the work in early though, the sky is the limit on how much you can make passively with a course.
Advantages of Passive Income
The time spent setting up passive income streams happens at the beginning. You will need to spend sometimes a substantial amount of time and effort to get it up and running. Once you get it going though, you can watch the money come in without any additional work. Think about someone who has multiple streams of passive income. You can enjoy life without worrying about hustling to make your next dollar.
Disadvantages of Passive Income
Similar to portfolio income, for many passive income projects you must have existing money. For example, owning rental properties requires a large amount of upfront capital to get started. Additionally, it takes a lot of work. It is not a get rich quick type of thing. You must be willing to sacrifice time and effort in the beginning before you start making your first dollar passively.
The Bottom Line
Most of us grow up thinking that the only way to earn income is by getting a job and trading time for money. Although there are benefits to this approach, there is very little freedom that comes with it. Building up passive and portfolio income streams allows you to continue making money while also giving you the freedom and flexibility to live the life you want.
