Three Types of Income: Active, Passive & Portfolio

It's critical to understand the various sorts of income in order to set financial objectives for the future and make the most of your money. The majority of people earn money through wages, salaries, and tips, however there are several more methods to earn money through other sources of income. 

 

We have defined income in this article and have also highlighted the three primary sources of income, including examples and tax information.

 

What is Income?

 

Income is money received by an individual or a business in exchange for labor, the production of a good or service, or the capital investment. Individuals usually earn money through wages or salaries, whereas corporations make money by selling goods or services for more than their cost of production. The majority of sources of income are taxed.

 

Depending on the context—for example, for taxation, financial accounting, or economic analysis—income is defined in a variety of ways. Individuals and corporations typically define income as the value or amount they receive in exchange for their labor and products.

 

Individuals typically regard their gross income to be the sum of their wages and salaries, as well as the return on their investments and property sales, and other receipts. Their net income is the difference between their gross income and the costs of creating that money.

 

Similarly, businesses treat their total receipts from services and products, as well as any interest and dividends received with respect to their cash accounts and reserves, as gross income. Businesses' net income (profit) is calculated by subtracting their gross income from their operating expenses.

 

Why Should We Understand the Three Types of Income?

 

Understanding the various types of income will assist you in making informed decisions, exploring investment options, and planning for a financially secure future and will also assist you in achieving your goals if you're looking for alternative ways to create money over a long period of time. 

 

It's crucial to look over the tax rates and timetables for passive and portfolio income streams so you can make informed long-term decisions. Understanding the various types of revenue can also be beneficial to:

 

1. Make money from your interests and passions.

 

2. Put money aside for retirement.

 

3. Invest in causes that you care about.

 

4. Extra cash can help you support your family.

 

5. Transitioning from a full-time job to a part-time job

 

6. Over time, progressively increase your riches.

 

7. Pay off your education loans.

 

8. Look for small-business partners.

 

9. Create your own little business.

 

10. Boost your financial self-assurance.

 

 

Types of Income

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Three Types of Income

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The three main types of income to consider are:

 

1. Active Income

 

You make money through active, also known as earned, income if you have a job and receive a paycheck. This essentially indicates that you're exchanging money for your time and energy, or your material participation. Wages, salaries, tips, and commissions are all examples of active revenue. 

 

If you work as a cashier at a grocery store, for example, the money you earn hourly is considered active or earned income because you're actively executing tasks and engaging with customers throughout each shift. 

 

Active income can also be defined as: Work in customer service, Composing and revising, Management, Advertising, Sales, Development of software, Designing a website, Marketing, Design for the web and Cleaning services
 

Advantages of Active Income

 

For those with a poor financial IQ, earned money is a suitable option. The formula is straightforward. I'll perform X for you, and you'll pay me Y. If you do your job successfully in a prosperous economy, you can bank on a certain amount of money flowing into your pocket every month. Many times, if you perform a good job, you will be given a raise, putting extra money in your pocket each month.

 

Disadvantages of Active Income

 

Many people who generate their money through work just have enough money to fulfill their basic monthly costs, leaving little or no money to invest. "Living paycheck to paycheck" sums up the situation for the majority of Es and Ss. They need to work more hours at their full-time job, part-time employment, or as a freelancer if they want to make more money.

 

Earned money, however, is exceedingly dangerous even for high-paid employees. Your job may be lost in an instant if the economy tanked or the company was mismanaged. Sadly, millions of individuals learned about this during the COVID catastrophe. And many of those jobs are just not returning. Worst of all, earned income is subject to highest taxation 

 

 

2. Portfolio Income

 

Dividends, interest, royalties, and capital gains are all sources of portfolio income. For example, you might acquire stock in a company at a cheap price and then sell it for a profit when its value rises. 

 

This is a capital gain that falls under the heading of portfolio income. Many people utilize portfolio income to put money down for retirement or to make major expenditures. Here are some further examples:

 

• Investing in a corporation as a shareholder

 

• To earn interest over time, open a savings account.

 

• Investing in royalties from books or music

 

• Purchasing small quantities of stock in a variety of companies

 

• Putting money into peer-to-peer loans (P2P)

 

• Investing in dividend exchange-traded funds (ETFs)

 

Advantages of Portfolio Income 

 

Portfolio income can help you make a significant amount of money in a short period of time. When the economy is booming, buying low and selling high can seem like a no-brainer. You can even get on the inside track of a rocket ship if you have insider information, such as day traders on Reddit who pushed up the price of GameStop a while back.

 

Disadvantages of Portfolio Income

 

Although portfolio income is speculative, it's difficult enough for knowledgeable investors to achieve consistent profits. As a result, it can be quite dangerous, especially for people with a low financial IQ who follow the herd. If you arrive late in the game, you risk being slaughtered by those who inflate the price, like many people did with GameStop.

 

The economy has an impact on portfolio income as well. When the entire housing market fell practically overnight in 2008, many people who were flipping houses had a rude awakening. Because a property is a slow-liquid asset, most people were unable to sell in time to recoup their losses.

 

 

3. Passive Income

 

Money earned via a rental property, limited partnership, or other business in which you are not actively involved is referred to as passive income. If you invest in a business but don't participate in its development, you're referred to as a "silent investor" who earns passive income. 

 

To grow and retain profit, passive income streams usually demand an initial investment as well as time. However, with little to no work on your side, investments like these can offer you with a steady stream of income in the future. Here are some more passive income examples:

 

• Obtaining customer loyalty through online book sales

 

• Equipment rental or leasing

 

• Getting properties to rent

 

• Affiliate marketing is a great way to make money

 

• From a blog or website, you can sell your own products.

 

• Becoming a co-owner of a company

 

• Investing in a blog or a website

 

Advantages of Passive Income 

 

The best thing about passive income is that once you have an asset, it will produce cash flow whether or not you are working. You have more time to do other things, like find other cash-flowing assets, because the money keeps coming in. Even better, cash-flowing asset gains can be used to buy even more cash-flowing assets. 

 

And, unlike portfolio income, you keep ownership of the original asset while using cash flow profits to buy other cash-flowing assets. It's the result of a compounding impact. Surprisingly, passive income is the least taxed type of income. It's almost as if the government is encouraging you to invest in this manner.

 

Disadvantages of Passive Income

 

To invest successfully for passive income, you need a high financial IQ and patience...two qualities that the vast majority of individuals lack.

 

The average person has a low financial IQ. It's not their fault, but the same people who were advised to go to school, obtain a good career, and invest in the stock market for the long term were also informed that their home is an asset. The belief was that your home's value will always rise.

 

Everyone discovered that belief isn't true only a few years ago (back in 2008). Some homeowners witnessed their home's worth plummet almost overnight. What these homeowners recognised was that their home was a liability, not an asset.

 

Also Read | Income Distribution

 

 

How do Taxes Affect the Three Types of Income

 

The government taxes most sources of income, and tax rates vary based on where your money comes from and how much you earn per year. Understanding how taxes may affect alternative sources of income is critical for properly planning for the future and calculating potential financial risks before they arise. 

 

When it comes to paying taxes on various sorts of income, there are a few things to keep in mind:

 

1. Active Income Taxes

 

Income tax money is often used to fund government actions and programmes, which are determined by federal and state budgets. The amount of money you earn in a calendar year determines your tax rate. 

 

Individuals with lesser salaries are usually taxed at lower rates than those with higher salaries, and tax rates may fluctuate over time if a pay raise occurs. If you get a promotion and a pay raise, for example, your income tax rates will rise in proportion to your annual salary and tax bracket.

 

2. Passive Income Taxes

 

The tax rate on each sort of passive income differs depending on how long you keep your investments and how much profit you make. Short-term capital gains are often taxed at a higher rate than long-term capital gains. 

 

For example, if you buy and sell a $8,000 stock in a year, you'll almost certainly pay a higher tax rate than if you own the stock for two or three years

 

3. Portfolio Income Taxes

 

Portfolio income, which includes dividends, capital gains, and interest, is taxed at a lower rate than earned income. Social Security and Medicare do not apply to portfolio income. The amount you owe is determined by how much money you make from each source of revenue each year, just like income tax rates.

 

Also Read | What is an Income Fund?

 

Active, portfolio gains, and passive income are the three major types of income.

 

Each of these sources of income can be helpful, and they will be taxed at different rates. Many individuals despite earning money, yet it can still be fulfilling and financially satisfying when combined with capital gains and passive income, allowing you to build your wealth even more.