The 3 Types of Income & Why You MUST Know The Difference

The 3 Types of Income & Why You MUST Know The Difference
23
Nov

Any time you’re earning income, your first thought should be — “How much of that do I get to keep?” In other words, “How much will I be taxed?” When you earn $100, how you earned it will determine how much of it will be surrendered to the government. Why should you care? Well, who wants to give up part of their hard earned money when they don’t have to?

In reality, there are three main types of income, and each type is taxed differently. How you earn your money will largely determine how much you keep. The more you can keep, the more you can continue to grow your wealth and build your legacy.

As we discussed in the article, taxes are one of the greatest wealth destroyers. Just by the type of income you earn, you could actually reduce or change your tax liability. Understanding how income works helps you build a more strategically sound income stream. It saves you from destroying your wealth.

Let’s take a look at the three main types of income:

1. Active Income

This is the kind of income we all start off with — it’s the income that you actively earn, by trading your time for money. Most people are earning active income, but the downside is that active income is also the most heavily taxed income.

The best example of active income is an employee or self-employed person working, trading their time and skill for an income. It could be hourly, or not, but they’re receiving the money because they’ve provided a service.

Within this category, there are still ways to strategize your taxes, but your options are limited.

2. Portfolio Income

This second type of income is portfolio income, which is income generated through capital gains in a portfolio of stocks, shares, etc. The tax advantages for this type of income are slightly better.

Say you buy shares in Apple, the price of Apple goes up, and you decide to sell those shares. The resulting profit will be taxed as capital gains tax, portfolio income. So it isn’t taxed as crazily as earned (active) income, but of the three it’s also not the most advantageous.

3. Passive Income Or Leveraged Income

Passive income isn’t really passive (or everyone would do it), but it is income that can be earned separate from portfolios and separate from your day job. Passive income is generated by leveraging the resources, skillsets, and unique abilities of someone else.

As an example, you and nine other people have pulled together the capital to buy an apartment building. In addition, you’ve chosen someone to operate this property and manage it on behalf of your group. Your group will still receive income, even though you have someone managing the property for you.

Another example would be receiving dividends on a whole life insurance contract — your overfunded life insurance contract where you warehouse your cash. As a policy owner, when the companies are profitable (which they have been for close to 200 years) you get to participate in the profitability of the company. Policy owners become shareholders because of this uniquely structured vehicle.

Royalties are yet another great example. If you’ve created intellectual property — a book, a song, or otherwise — and then license it out and collect royalties, you’re earning passive income. You could invest in oil and gas and make a profit, leveraging the expertise and skills of those involved in energy. Investing in any business as a passive investor is the same, and requires strategy.

One of my favorite leveraged investment asset classes is energy, like oil & gas exploration projects and or shale gas projects, where you not only receive great cashflow but receive great tax benefits that reduce your overall income through depreciation strategies.

There are many ways to earn a passive income if you’re strategic enough, and as such it’s the most tax-advantaged of the three income types.

Creating a Holistic Wealth Strategy

You could argue that there are more than three types of income, and really break it down, but I think these three elements give you the most digestible explanation. When creating a wealth strategy, you’ll want to be combining the different types of income in order to keep as much of your income as possible. Many of us start out earning an active income until we can begin to build portfolios, which eventually allow us to earn a passive income. Don’t be afraid to build your own strategy, however, and find something that works for you. For example, whole life insurance will be more optimal the earlier you start it, or maybe you’d like to write a book or two alongside your day job.

One of the bestselling personal finance books out there is Rich Dad, Poor Dad by Robert Kiyosaki, which has touched the lives of millions of people. I’m willing to bet you’ve at least heard of it, that’s how popular this book is. I’ve had the pleasure of interviewing him twice on Cashflow Ninja, but Kiyosaki also has another book called Cashflow Quadrant. I highly recommend this book, which explains the four main ways people operate when it comes to economics.

The left-hand side of the quadrant has an E, for “employed,” and an S for “self-employed.” This half of the quadrant explains people who are working actively for their money. The right-hand side has a B for “business” and an I for “investor.” It describes people who are no longer solely exchanging time for money, and it also indicates the most tax-favorable income options.

The goal when you’re crafting a strategy is to understand the types of income out there, and which quadrant you belong to, so that you can keep progressing. The goal for all of us should be to end up in the I quadrant. That’s when you stop exchanging time for money, and begin leveraging your assets to generate income.

When you combine this understanding with an understanding of taxes, like we discussed previously, you can begin to strategize your wealth in a way that many people don’t consider. You have to think like an Investor if you want to reach that quadrant. So you use your active income to create assets and wealth which is more tax-favorable, and build strategies that increase your revenue while decreasing your taxes. You keep working your way to the right side of the quadrant.

You can listen to my new podcast, Cashflow Investing Secrets here.

Live your Freedom, Live Your Legacy, On Your Own Terms,

M.C.

M.C. Laubscher is a husband, dad, podcaster & Cashflow Specialist. He helps business owners and investors create, recover, warehouse & multiply cashflow. You can learn more about exclusive cash flow strategies in M.C.’s new video series at https://www.yourownbankingsystem.com/

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