Do you know that there are three types of income? Earned income, capital gains income, and passive income. In our society, we have a perception that getting a high-paying job is the only way of getting prosperous. The only way to earn an income is to work for an employer and receive a paycheck, the more and faster person receives it, the easier to get rich.
We call this is a type of income as “earned income.” This is a type of income that you actively earn by doing work for someone else. Earned income is not the only way to earn money nor the best way to reach financial freedom. In this article, we will introduce three different types of income that you can use to build wealth.
1. Earned Income
The first type of income is the most common income. Earned income is the income that you receive in exchange for doing work for someone else. When you start your financial journey for the first time, this is the only type of income that you will be able to earn. This type of income also includes wages and salary.
Wages are an income from a job where you are paid an hourly fee to perform specific activities. You earn more money if you work more hours. While salary is an income earned through employment. Your annual income is normally determined by a contract and paid weekly or monthly. Typically, the payment is consistent, and you will not be compensated for additional hours worked.
Examples:
– Working as a salaried employee at organization;
– Doing an hourly consultant for clients/organization
2. Capital Gains Income
This is the type of income that you receive from selling an asset or investment for more than the amount you paid for it, we also call it “portfolio income”. Investments, dividends, interest, and capital gains all contribute to portfolio income.
Examples:
– The most common example of capital gains income can be buying a stock for a certain price and selling it for a higher price later.
3. Passive Income
Passive income is money that would keep coming in even if you didn’t do anything. This is the type of income in which you get earnings from a rental property, limited partnership, or other enterprises that require no work on your part. When you are at higher points of financial freedom, this is the channel of income you should definitely consider.
Examples:
– Property rentals
– REITs investment: A REIT is a (real estate investment trust) is a company that owns income-producing properties.
Must Read: The Best 5 Passive Income Ideas You Should Consider
Additional Types of Income
Dividend Income
Dividend income is money received from owning shares in a company. When companies make a profit, they can distribute a portion of these profits to shareholders in the form of dividends. There are ordinary and qualified dividends, with the latter being taxed at a lower rate.
Examples:
- Stocks: Dividends from investments in dividend-paying stocks. Shareholders receive regular payments based on the number of shares they own and the company’s profitability.
- Mutual Funds: Dividends from mutual funds that invest in a portfolio of dividend-paying stocks. These funds distribute dividends to their investors.
Key Features:
- Shareholder Earnings: Earned as a shareholder in a company. Dividends provide a share of the company’s profits to investors.
- Regular Payouts: Often paid quarterly. Companies may distribute dividends on a regular schedule, providing a steady income stream.
- Tax Advantages: Qualified dividends are taxed at lower rates. Depending on how long the shares have been held, qualified dividends can benefit from lower tax rates compared to ordinary income.
Interest Income
Interest income is earned by putting your money into interest-bearing accounts or instruments like savings accounts, treasury bills, or bonds. This type of income is relatively low-risk and provides a steady stream of earnings.
Examples:
- Savings Accounts: Earnings from interest on savings accounts. Banks pay interest on the money deposited in savings accounts.
- Bonds: Interest from corporate or government bonds. Bondholders receive regular interest payments from the issuer.
- Certificates of Deposit (CDs): Interest earned from long-term savings instruments. CDs typically offer higher interest rates than regular savings accounts in exchange for locking in the deposit for a specified period.
Key Features:
- Low Risk: Generally low-risk investments. Interest-bearing accounts and bonds are considered safer compared to stocks or real estate.
- Stable Returns: Provides stable and predictable returns. Interest income offers consistent earnings over time.
- Taxable: Subject to ordinary income tax rates. Interest income is taxed as ordinary income, which may be higher than the rates for capital gains or qualified dividends.
Rental Income
Rental income is generated from renting out properties or assets. Real estate investments are a common source of rental income, offering a reliable way to build wealth over time.
Examples:
- Residential Properties: Income from renting out houses or apartments. Landlords collect monthly rent from tenants.
- Commercial Properties: Earnings from leasing office spaces or retail properties. Businesses pay rent to use commercial properties for their operations.
- Vacation Rentals: Income from renting out vacation homes or Airbnb properties. Short-term rentals can generate higher income during peak travel seasons.
Key Features:
- Asset-Backed: Income generated from tangible assets. Real estate provides a physical asset that can appreciate in value.
- Long-Term: Provides long-term income potential. Rental properties can generate income for many years, contributing to financial stability.
- Tax Deductions: Eligible for various tax deductions. Landlords can deduct expenses related to property maintenance, repairs, and depreciation.
Royalty Income
Royalty income comes from licensing something you created, such as music, books, or software. This type of income can be highly lucrative, especially for creators and inventors.
Examples:
- Books and Music: Royalties from book sales or music streams. Authors and musicians earn royalties from the sales and use of their creative works.
- Patents and Trademarks: Income from licensing patents or trademarks to other businesses. Inventors receive royalties when their patents are used by others.
- Software: Royalties from software licenses. Software developers earn income from licensing their software to users or businesses.
Key Features:
- Creative Earnings: Earned from creative works or intellectual property. Royalties provide ongoing income from the use of these creations.
- Recurring Income: Provides recurring income over time. Once established, royalties can generate continuous earnings.
- High Potential: Can be highly lucrative depending on the popularity of the work. Successful books, music, or inventions can generate significant income.
Understanding Income Types
Understanding the different types of income is crucial for effective financial planning and wealth-building. Each type of income has its own tax implications and potential for growth.
Tax Implications
Different types of income are taxed at different rates. Earned income typically faces the highest tax rates due to FICA contributions. Capital gains and dividend income can benefit from lower tax rates if they meet certain criteria.
Tax Strategies:
- Tax-Deferred Accounts: Utilize tax-deferred accounts like 401(k)s and IRAs to grow investments without immediate tax liabilities.
- Capital Gains Management: Hold investments for more than a year to benefit from lower long-term capital gains tax rates.
- Dividend Reinvestment: Reinvest dividends to compound growth and defer taxes on the income.
Diversifying Income Streams
Diversifying your income streams involves creating multiple sources of revenue to enhance financial stability and growth. Relying solely on a single source of income, such as a traditional job, can limit your financial potential and make you more vulnerable to economic fluctuations and job loss. For a deeper understanding of why diversification is important, you can explore more here. By incorporating different types of income, you not only spread risk but also open up opportunities for greater financial success.
There are various ways to diversify your income streams, each with its own benefits and considerations:
- Earned Income: This is the money you make from working, whether through a full-time job, part-time work, or freelancing. While it’s often the primary source of income, it’s crucial to recognize that it’s limited by the number of hours you can work and may be subject to high taxes.
- Investment Income: Investing in stocks, bonds, real estate, or other assets can generate passive income. This type of income can provide growth potential and financial returns without requiring active involvement. However, it also comes with risks and requires research and strategy.
- Rental Income: Owning rental properties can provide a steady stream of income. This can be a reliable source if managed well, though it involves property maintenance and management responsibilities.
- Royalties: If you create intellectual property such as books, music, or patents, you can earn royalties whenever your work is used or sold. This can be a lucrative income source with the potential for long-term returns.
- Online Ventures: Starting an online business, such as an e-commerce store, blog, or YouTube channel, can offer additional income streams. While it may require upfront effort and investment, it can generate revenue through advertising, affiliate marketing, and sales.
- Side Hustles: Engaging in side hustles like consulting, tutoring, or gig economy jobs can supplement your main income. These opportunities often allow you to leverage your skills and interests for extra earnings.
By diversifying your income streams, you can mitigate the risk of losing your primary source of income and potentially reduce your overall tax burden. This approach not only enhances your financial stability but also provides more opportunities for wealth accumulation and personal growth.
Must Read: 6 Tips on How to Build Portfolio Diversification
FAQs
1. What is earned income? Earned income is the money you receive in exchange for working for someone else, including wages and salaries. It is typically taxed at the highest rates due to the combination of ordinary income rates and FICA contributions.
2. How is capital gains income taxed? Capital gains income is taxed based on how long you have held the asset. Short-term capital gains (less than a year) are taxed at ordinary income rates, while long-term capital gains (more than a year) are taxed at lower rates.
3. What qualifies as passive income? Passive income includes earnings from rental properties, limited partnerships, or other ventures where you do not actively participate. It is not subject to FICA taxes, making it a favorable income type for tax purposes.
4. How can I start earning dividend income? You can start earning dividend income by investing in dividend-paying stocks. It’s important to research and choose companies with a history of stable and growing dividend payments.
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