Are you looking to diversify your sources of income? If yes, the first thing you need to learn is different types of income that can contribute to your wealth. Here is a detailed guide.
Most of us have a fixed idea of earning an income, which involves sitting in a cubicle for 9 hours to get money deposited into our accounts every month. The cycle continues until we retire and survive on a pension for the remaining part of our lives.
Only, it doesn’t always have to be that way.
When you come to think of it, you can earn through a variety of different ways, even more than what you are making right now. There are many other types of income that promise you financial independence in the early stages.
This post will explore the different types of incomes that you need to know, along with the merits and demerits of each.
Table of Contents
What is Income?
Before we start exploring the different forms of income, you need to understand the basic idea of income. Even though it might seem most probable, income is not limited to one kind. Neither should it be if you are trying to make ends meet.
Income is any amount of money that you earn during a specific time period in exchange for providing goods or services or through capital investment.
Individuals receive payment in the form of wages or business earnings. You can also earn by investing in financial assets such as stocks, real estate investment, and bonds.
The primary sources of income for retired people are usually investments, pensions, and social security. Taxation authorities impose taxes on different grounds based on varying means of income.
Disposable and Discretionary Income
Disposable Income is the money that you are left with after you have paid the taxes. You can spend disposable income on your basic necessities such as groceries, transportation, etc.
Discretionary Income is the money you are left with after you have paid all the necessary expenses. You can either save the remaining income or spend it on vacations, eating out, movies, etc.
Different Types of Income
What are the different types of income, you might ask? One type of income involves spending your day behind a desk and waiting for a paycheck every month. But, that’s just one form of income, which is known as Active or Earned Income.
If you want to earn better, you don’t have to limit yourself to this one type. In some types, you have to work, while in others, your money does the work for you.
What does type of income mean to you? Diversifying your understanding of income types can help you retire early and prove to be an effective way to have better income sources.
Let’s start with the following 3 types of income: Active Income, Passive Income, Portfolio Income.
Active or earned income is probably the most common type of income that is received in exchange for providing services or working independently.
When you start your financial journey, this form of income will be your only way to earn. It includes salaries, wages, commissions, and income from businesses.
Active Income is usually based on a contract between you and your employer. If you get lucky enough to get a high-paid job, you can make decent money from this type of income.
Apart from Earned Income and Self-Employment Income, Active Income can also come from one-off events such as selling used things, taking online surveys, etc.
There are many other unconventional active ways to earn without having to sit in an office cubicle.
The most common ways of Active Income include:
- An hourly employee for a company
- A salaried employee at a company
- An hourly consultant for a company
- A fixed-rate freelancer for companies
Pros of Active Income
One significant advantage of Active Income is that it is a much faster way to earn than the other two types of income.
This type of income means that you receive payment for your work right after you have completed it or within a month at most.
Whether you are an hourly or salary employee at a business, you will get paid within a few weeks, which is relatively quick.
A stable monthly income makes a steady point to start your financial independence journey. It gives you the opportunity to build a solid foundation before you decide to jump off.
Moreover, Active Income works on a simple principle: the more time you give, the more cash you make. However, as time passes, you become more experienced, and without a promotion or raise, you might feel that you are underpaid.
Cons of Active Income
To earn Active Income, you have to give your time to your job to get your paycheck.
Usually, that means working for six to eight hours for at least five days a week. This time excludes the time spent on transportation and answering work-related emails when you are home.
If you are passionate about your job, this might not be a lot. But, you might not remain motivated enough to spend so many hours in an office in exchange for money. And, the amount might become too less for you over time.
Additionally, you have to top in your area of expertise to raise your income potential, and that’s not always easy. Even if you get a promotion, you might get to a point where you would not want to move up anymore.
Even if you are working as a consultant or a freelancer, you have deadlines to meet and improve your work quality to compete for better income.
Passive Income is a highly sought after way to make money from owning assets. In this type of income, you don’t do anything continuously but keep your money rolling.
It is the broadest type because it includes a variety of projects, ways, and ideas to generate income.
When a company makes a profit, it might decide to reinvest the money into the business to grow. Or, it may pay some of the profits as dividends to the investors.
This way, you can receive a specific amount of money every three months if you invest in a stock or a stock index fund.
Real Estate Investment
Another way to earn passively is to rent properties that you own. You can buy a house or an apartment, specifically to rent to start earning from it. When it has served its purpose, you can move into the property or sell it.
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A Real Estate Investment Trust or REIT is a company that owns properties that produce income. You invest in a REIT to receive your dividend payment every three months.
It is a straightforward way to earn from a rental property without going through the hassle of owning a property.
As you can earn this way without doing anything, you have a lot of time to do what you love, travel, and vacation at your dream locations. Plus, you never have to stay in one place to earn passively.
Passive Income often requires capital and a great deal of effort to start with.
Once you have put in the time and effort, cash comes flowing in for you and your family, regardless of your location or condition. You can be making money while you are asleep!
The most common ways of Passive Income include:
- Real Estate/Rental properties
- REITs (real estate investment trust)
- Intellectual Property (libraries, smartphone applications, ebooks)
- Affiliate Marketing
- Passive Income Apps
- Network Marketing
Pros of Passive Income
With Passive Income, you don’t have to spend your days in an office to earn. Once you set up your income source, you can produce income while you are sick, vacationing, or sleeping.
Passive Income gives you the financial flexibility you need to become financially independent. Moreover, you don’t need hefty capital for some projects as they only require planning and creativity.
Cons of Passive Income
On the downside, this income type is still time-intensive, energy-intensive, and requires a lot of thinking on achieving your goals. You might have to work hard in the beginning to kick start and stabilize your source of income.
Furthermore, while it’s thrilling to receive money from stock, it takes quite some time to save for the initial investment. Also, if you are trying to earn from a source that has to be created from scratch, like a blog, you have to be very committed in the beginning.
Nonetheless, passive income is a great way to make good money without working continuously for the rest of your life.
Portfolio or Capital Gains Income is received from selling an investment for more than the paid amount. It is earned from stocks, dividends, bonds, and interest. That is why it can be characterized as a subset of passive income.
The royalties from property held for investment is counted as Portfolio Income.
It is also earned through capital gain. For example, when you sell a stock or a property for more than what you paid for it. If you buy a stock for $150 and sell it in the market for $300, you have earned $150 as capital gains.
Dividend incomes come from owning a fund or stock. After a certain amount of time, the companies pay cash dividends to their shareholders out of their profit. It is an effective way to diversify your streams of income and cash flow.
The most common ways of Portfolio Income include:
- Real Estate
- Currency Exchange
Pros of Portfolio Income
Portfolio Income is an effective way to diversify your income and make your money do the work for you. You can start with a small investment and wait for it to increase so that it can make a large difference in your life.
You can make use of investing apps that help you start with as little as $5.
Another advantage of this form of income is that when you earn Capital Gains Income, you will be paying capital gains tax. If you hold the stock for a long time, you will have to pay taxes at a lower rate, which is dependent upon your ordinary income.
Moreover, if you sell an asset in a short time, you will have to pay short-term capital gains taxes, which is the same as ordinary income tax rates. However, if you sell the asset at a higher price after you have owned it for more than a year, you will have to pay long-term capital gains taxes.
Cons of Portfolio Income
One obvious drawback of this type of income is that you need to have existing money to invest in assets like stocks, bonds, and real estate. It will take a significant amount of time to accumulate the initial investment needed to earn through capital gains.
Some Other Income Types
Apart from these 3 types of income, you might hear a few other types. These include:
Gross Income is the amount of cash you receive before taxes and any other deductions. You can find it on your payment check.
This type of income is gained through ownership of land, inheritance, and social security.
Adjusted Gross Income
AGI is the earnings of a salaried employee with no other business interests.
Taxable income is your Adjusted Gross Income without any deductions. Your tax bill can vary depending on whether you take the standard deduction, filing status, and other factors.
How to Gain Financial Independence
By using these three types of income, you can set and diversify your streams of income that will allow you to retire early. It might take some planning and time at the start, but it will be well worth it.
Through a combination of the three major types of income in economics, you can gain riches without much trouble. An effective way is to start with Active Income and save to grow your money in the next step.
If you cannot save through a traditional 9 to 5 job, consider working outside of the office environment.
Once you have saved for about a year’s worth of expenses, only then you can start investing in the market. The first place to invest is in your tax-advantaged savings accounts. Stocking up your 401(k) and IRA is a good way to save and prepare for future investments. Then, move outside of these accounts for serious earning.
You can earn through capital gains and dividends, or perhaps go the route of real estate property and REITs. At this point, think about all the reasons why you are investing. It will help you answer tough questions and choose the right path.
Once you know which route to take, you are all set to make a long term investment plan. This step is the key to building a stable income source.
You can then look into options to earn Passive Income, as that is the only income you don’t have to save for retirement. It is the ultimate way to financial independence.
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