We tend to think of income as the money generated by our labor, however, there are other types of income that should be considered. Understanding this allows us to create solid financial goals, and improve our financial future. Most of us are used to generating income through labor, receiving salaries or wages, perhaps even tips. However, there are more types of income to consider. Alternative ways of earning money that allow you to diversify your income streams.
Why is it important to understand the different types of income?
Above all, understanding the different types of income allows us to diversify our income streams. It opens the door to untapped income streams that can improve our financial future. It will also contribute to helping you make better financial decisions. Possibly even exploring new investment opportunities.
It also allows us to financially plan our futures, in a structured and goal-oriented approach. This is a key step to achieving your financial goals. Some other aspects should also be considered like taxes. If you need help saving for retirement, or perhaps gaining confidence to start investing or paying off your debt, understanding the different types of income is an important step.
The 3 types of income
Income is usually categorized into three types - Active, Passive, and Portfolio. Within each of these types of income, there are other subtypes depending on the specific income source, and its type. Being able to diversify your income streams means taking advantage of this and creating income sources of all of the types available. Here are the main types of income:
- Active income
- Passive income
- Portfolio income
Active income is a type of income that requires effort and to dedicate some time to. Although some of the subcategories of types of income can both fall on active and passive income, for most of us active income is what generates the bulk of the money we make throughout our lives. When we are employed and receive a salary, active income represents our wage. Active income simply represents selling our time, for a certain fee. Active income includes earned income and profit income.
Some examples of active income include:
Advantages and disadvantages of active income
Advantages of active income:
- No upfront capital required
- It is easy to get a job
- Income is more certain
- Less risk
Disadvantages of active income:
- Impossible to scale
- High taxes
- Getting a raise is difficult
- Salaries are oftentimes fixed even if you put in additional effort
- Risk of getting fired
Passive income encompasses various types of income. It could be generated through a company or a partnership that you own entirely or partially. If you invest in companies but are not actively involved in the day-to-day management, any proceeds that you receive from this is also considered passive income.
Passive income is one of the most important things to build generational wealth. There are several passive income books that can help you build passive income streams. In fact, some people would argue that it is the quintessential part of building wealth. However, to create passive income sources you will most likely have to make investments. This means that you will need some initial capital to put to work.
Advantages and disadvantages of passive income
There are several advantages of passive income, and in fact, they surpass the possible disadvantages.
Advantages of passive income:
- Highly scalable
- Lower taxes
- It requires less time
- Low effort long term to maintain
Disadvantages of passive income:
- High initial capital required
- High initial effort
- Requires more skills than active income
Portfolio income is perhaps the pinnacle of creating wealth. Once you have developed your active and passive income sources you can then start building your portfolio income. Portfolio income is usually referred to as interest, dividends, royalties, and other income generated by your investment portfolio. It also includes capital gains generated by your investments.
Although most of us tend to think portfolio income is something you can only build when you are wealthy that is not the case. In fact, those of us that only have active income streams are able to save and invest those savings into growing their portfolio income.
Building your portfolio income is also extremely useful when saving and preparing for your retirement. A great advantage of portfolio income as opposed to passive income, is that the effort, time, and dedication required to build this type of income is much lower. Therefore even if you only have an active income source, you can start creating a portfolio that allows you to generate additional income.
Some examples of portfolio income include:
- Capital gains
Advantages and disadvantages of portfolio income
Advantages of portfolio income:
- It requires less time than active and passive income
- It does not require a lot of capital to start
- Lower taxes
- Allows you to diversify easily
- Requires less effort
Disadvantages of portfolio income:
- It requires significant capital to generate a high income
- You require a specific set of skills
- Limited influence and control
Image source: Listen