As you get older, you start to realize that there are different types of income. In fact, those various types are what helps you live more comfortably, increase your net worth, and reduce financial stress.
But for most of us growing up, the only income we typically are aware of is the one related to our future job.
While income from your career or workplace is certainly an important means to make a living and have access to life’s essentials, it’s not the only income that matters.
As I taught myself personal finance over the years, I quickly learned how mastering different types of income will greatly impact my life.
And if growing your financial stability or reaching financial independence intrigues you, then having multiple income streams will be incredibly important to you.
Why Different Types of Income Matter
There are different ways to earn money, and understanding how each method works along with its advantages and disadvantages can help you increase your overall income and reach your goals.
Although they all require some kind of work, some types of income can increase exponentially, while others can return an income long after you’ve put in the work.
Every type of income is also taxed differently, so you could essentially keep more of your money by making the most of them. The more money you can keep, the more you can keep growing your wealth and reach your goals.
Additionally, one stream of income can completely disappear. Instead of panicking or relying solely on an emergency fund, you now have back ups that can reduce stress.
Just like it’s important to diversify your investments, it’s important to diversify income streams.
Below I’m going to share more about the three common types of income and some additional ones beyond that.
Three Common Types of Income
So what are the three common types of income you must master? Well, this includes earned income, passive income, and capital gains income. I’ll explore each a bit more below!
1. Earned Income
Earned income is the most common type of income. This would be the income you earn from your job through your paycheck. It’s usually earned by working in a company at a fixed rate every month.
Examples of earned income are:
- Working per hour at a company
- Working part time or full time for a company
- Being a salaried employee for a company
- Freelancing/consulting for clients or businesses
The main advantage of earned income is that it’s relatively easy to get started with. You usually get paid on some recurring basis like weekly, bi-weekly, or at the end of the month.
And you can find jobs in all kinds of sectors for all different sets of skills.
Plus, while job hunting is not always fun it doesn’t require upfront money to get started and is less risky compared to other types of income.
A disadvantage with earned income is that you will need to exchange your time for money. In order to receive your money every week, you will need to work the required hours (or more).
This may include the time you spend in commute, and you may need to work extra hours too. In addition to that, earned income has one of the higher tax rates when compared to other forms of income.
Additional disadvantages include:
- If you lose that job, your income is also gone
- You might hate your job or company you work for
- Become just cog in the machine
2. Passive Income
Passive income is the type of income where you receive money from assets that you have put money into or also worked on in the past. This is something you’ve already put the effort in and are reaping the benefits now, with much less effort.
Some examples include:
- Buying a house and renting it out
- Stocks that pay dividends on a recurring basis
- Affiliate marketing on websites or blogs
- REITs – real estate investment trusts
- Crowdfunding investments like Masterworks or Fundrise
The benefit of receiving passive income is that you are no longer exchanging time for money. Instead, you are literally making money while you are sleeping.
You will have more control over the investment which could impact the success of that investment down the road.
One other advantage is that passive investments can also pay lower taxes. And for some investments, you’ll also be able to fund your venture on borrowed money — such as a mortgage for a house or angel investing for a company.
The disadvantage is that you will need to put in a lot of upfront work to create this passive income stream, and it’s not guaranteed that it will be successful.
Additionally, you may need to contribute a large amount of money at first (like with dividend investing) and will need to learn some skills in order to make the most of your venture.
3. Capital Gains Income
Capital Gains income is also sometimes called portfolio income, and is income that you receive for selling something at a higher price than you bought it for.
It’s called capital gains income because capital gains tax is what you pay for the profit you make. Some examples of capital gains income are:
- Buying and selling stocks, bonds and mutual funds
- Buying and selling real estate
- Buying and selling collectibles or valuable commodities like gold
There are also some differences between short-term and long-term capital gains income.
Short term may be selling stocks a few days after buying them, whereas long term would mean assets you’ve held for a long time and are selling later on, like real estate.
For example, you may be invested in various Vanguard Index Funds, but let’s say you bought one particular fund for $500. Eventually, you decide to sell it when the price is worth $1,000. That would leave you with a $500 capital gains income.
The main benefit of capital gains income is that it won’t require as much work as other types of income.
With something like buying stock and selling it later on, you will receive the income without having to make too much of an effort, and will mostly benefit from holding and selling at the correct time.
The other benefit is that this kind of income is one of the most optimized for taxes. Capital gains taxes are lower than income taxes which means you’ll be able to keep more of your money.
However, there are some disadvantages too with capital gains income. For one, this kind of income does require some knowledge.
With stocks and bonds, you do want to know which companies you are investing in, and that does require some research.
With real estate, you will also need to be eligible for a mortgage and have the time and resources to research the best properties.
And many times, with these assets, you won’t have a lot of control — you’ll only be able to buy and sell.
Finally, this type of income usually requires quite a larger upfront investment. If you want to make large gains, you’ll need to put in a large investment.
Other Types of Income
The above three are the common types of income, but we can go even a step further. There are two others to understand a bit further as well.
Technically, this fits into the “passive income” bucket, but it’s worth expanding further.
Buying property and letting it out to tenants is a well-known and reliable way to make an income. House prices are quite high, which means that many people will always be renting.
With this type of income, you will need to do the research and decide on which types of properties you want to buy and sell.
You’ll likely need to apply for a mortgage, and do the calculations so you make sure the income you receive from your tenant covers your mortgage and leaves some left for you.
The main advantage of rental income is that you will receive a recurring income every month from your tenants. The money arrives directly into your account and you can pay your expenses and mortgage with that same account.
Over the long term, not only will you be receiving rental income, but the value of your property will also increase over time.
You’ll also be eligible for certain tax benefits and be able to deduct certain property management costs, insurance and other depreciation costs from your profit as a landlord.
The disadvantages are that you will be responsible for your renters. If your apartment is flooded or the neighbours are noisy, you’ll be the one in charge of maintaining the property.
Although you can hire property managers to help you out, you still want to remain in control so you make sure they don’t overcharge you.
Managing a property can be a lot of work, and you can end up in difficult situations where you need to evict tenants or take them to court.
The other drawback is that investing in rental properties requires a significant amount of upfront investment.
This can take a large portion of your net worth, and it’s not exactly diversified: if something happens to the neighborhood or house, your net worth does take a big hit.
Inherited income is quite straightforward: this is the income you would receive from parents or other family after their death or even set in trusts.
You would receive an estate through the inheritance that usually comes in the form of cash. Additionally, you may also receive it through assets such as real estate or stock market funds.
Once the family members are deceased, you will be walked through an estate planning process where wills are written, inheritance tax is paid and the beneficiaries receive their portion of the estate.
But there are many instances of generational wealth and family money that is passed down for years and years.
Think about some of the well-known family dynasties in the world, much of the wealth is inherited, through forms of cash, assets, and business ventures.
The obvious advantages are you potentially are getting a ton of cash and assets for doing little to no work. Just being part of a wealthy family can be all it takes to inherit money.
While earned income can sometimes be looked down upon by entrepreneurs and “business gurus” it can still be rewarding and financially satisfying.
However, the best thing you can do is master the different types of income above. Even if you don’t pursue every avenue, find ways to increase your income streams beyond just your job.
And maybe, you’ll even move away from earned income and start your own business, become interested in more income producing assets, and discover your path to financial freedom.
Whatever you decide is a personal decision, but always remember the value of more than one income stream.