3 Types of Income
Financial education is fundamentally important to everyone. Unfortunately, it’s not a topic that is readily covered in school or college.
In order to improve financial literacy, you must do your own research and reading. After that, life experience is the only way to learn more and become better educated.
If you would like to be wealthy and financially free, you need to know the difference between 3 types of income:
- earned income
- portfolio income
- passive income
All 3 types of income (earned, portfolio & passive) provide ‘cash flow‘ or ‘cashflow‘. It’s a necessity. Nobody can live without cashflow of some sort, whether it’s generated from working at a job, through passive income sources, or assistance from the government. As you already know, cash flow provides money to pay for:
- everyday expenses (mortgage/rent, food, clothes, entertainment etc)
- emergencies (health or family)
- more assets (real estate, crypto, business, commodities, paper assets for more cash flow)
- doodads (vacation, cars, boats and other things that depreciate and don’t provide additional cashflow)
All 3 income types mentioned in this article provide cash flow (which is ‘cash in the bank’). However, the types of income and the cashflow generated are NOT EQUAL. Far from it. This is why financial education is so important.
It’s really not about ‘how much income you make’ but ‘what type of income’, ‘what type of cashflow’ and ‘how much do you keep’ that’s much more important. Read below for more details.
They are all considered ‘income’ and they all provide ‘cash flow’. But they are NOT equal.
Unfortunately, the majority of people in this world never learn about different income generation opportunities and the different types of cash flow derived from these income sources. In fact, many people are not given the chance to learn or be educated financially, which is a big shame. Most people are also unaware that there are different income sources. It’s not all about going to work and getting paid. There are many other ways and types of income to consider when you want to retire early and be financially free.
In most families and societies, ‘status quo‘ is most important. You’ll often hear this advice: “go to school, pay attention, get good grades, graduate, go to college, graduate, get a job, get a better paying job, climb the ranks, have a ‘diversified portfolio’ including stocks, bonds, mutual funds and a primary residence (house).” This might work for some people, but for most, this advice and life strategy will not help them get out of the ‘rat race’.
3 Types of Income in a Nutshell
Here are the major differences between earned income, portfolio income and passive income. This includes what they are, advantages and disadvantages of each and examples.
|Where does income come from?||Income derived from a job.||Investment capital gains||Assets that provide consistent cash flow|
|Who earns this type of income?||Employees and self-employed||Investors||Business owners and investors|
|In a nutshell:||Trade time for money||Trade capital gains for money||Money comes in regardless of whether you work or not|
|Explanation:||Any job where you are paid a predetermined amount of money (X) to do a job for a certain amount of time (Y).||Any investment in stock or real estate whereby an investor buys at a certain price and sells higher.||Any asset that produces cash flow like rental property, book royalties or interest/dividends.|
“I earn $100k per year based on a 40-hour work week”
“I bought stock at $10 & sold for $40”
“I make $2,000/month from my rental property”
|Advantages:||Stability and security with the possibility of a raise and bonuses in the future.||Can make a lot of money in a short period of time. Accessible. Buy low and sell high.||Consistent cash flow leaving time to do other things and $ to invest more (compounding).|
|Disadvantages:||Fixed income prevents people from getting out of ‘rat race’ unless they work extra hours outside of their job. You can get fired and most ‘live paycheck to paycheck’.||Since most people have low financial IQs, making money through portfolio income is oftentimes risky and speculative. Short-term thinking can lead to many challenges.||It takes a high financial IQ and patience, which most people don’t have. Positive cashflow generating assets require a lot of research, analysis and time.|
|Taxes:||Earned income is the most highly taxed form of income. Most ‘middle to lower-class’ people are taxed in this bracket. Up to 50% tax rate.||Portfolio income can be taxed like earned income (if flipping) or lower if asset is kept more than 1 year. Usually between 10-20% tax rate.||Passive income is the least taxed form of income. Most income sources are setup for business owners and the tax rate can be as low as 0-5%.|
|Financial IQ required:||LOW||MODERATE||HIGH|
As you can see, the 3 types of income are very different in a multitude of ways. Those with higher financial education and financial IQs will be more attracted to passive income and portfolio income. People with lower financial IQs will gravitate towards earned income and portfolio income, with the latter usually in the form of risky bets, speculation and short-term thinking.
Financial education is the most important type of education in today’s world. However, only a fraction of people will have the opportunity and time to learn and gain experience to increase their Financial IQ.
Most people are satisfied with the stability and security of earned income through a job. Not only is earned income the most highly taxed, but this perceived security can be turned upside down during tough economic times (like during the COVID pandemic). The COVID crisis exasperated the increasing divergence between the middle to lower class and the wealthy. Many lost their jobs and their entire income source with no financial backup through portfolio or passive income. Sadly, they had to rely on government handouts which were delayed and very small. In some countries, the handouts are taxable too, leaving even less money to ordinary people.
Some people dive into the world of portfolio income through stock equities and flipping homes for capital appreciation. It’s usually called ‘timing the market‘. However, capital appreciation is NOT guaranteed, even with time. People with low financial IQ will gravitate towards taking unnecessary risks and speculative investments. Many get burned and lose all of their money through these risky bets. People with high financial IQ learn to mitigate risks in earning portfolio income using patience and proceeds to purchase assets generating passive income.
Only a handful of people will fully understand the power and advantages in earning passive income. Assets that give you consistent cash flow is the key to retirement and to become financially free. Essentially, you can collect passive income whether you are working or not. You let the asset do the work for you. It’s also the type of income that is taxed the least. However, only people who are financially educated with a high financial IQ will have the skills and patience to invest in assets that provide passive income.
Hopefully this article gives you more insight into the 3 types of income and how they are different. Each has its advantages and disadvantages, but passive income is by far the type of income that will get you out of the ‘rat race’ faster and with less risk.