Use Multiple Types of Income to Reach Financial Freedom
There are three primary types of income. Diversifying your income streams can help you take control of your personal finances.
Contributing Writer at Tally
January 28, 2022
The information provided is for informational purposes only and should not be considered financial advice. Consult with a financial professional to determine what may be best for your individual needs.
If you're looking to take hold of your financial future, you may want to consider building multiple types of income. Doing so can increase your earnings, providing you with the flexibility to do things like paying off debt or reaching savings goals. It can also help protect you when unexpected circumstances arise, such as losing your job.
The three primary types of income
Why it's important to have different types of income
How you can begin working toward that goal
What is income?
Income, in a nutshell, is money that you receive. You’re likely most familiar with income in relation to wages or salaries. The money you make from working a job is one type of income. However, as outlined below, you can earn in different ways.
What are the different types of income?
There are three types of income:
Active income, otherwise known as earned income or ordinary income
Passive income, otherwise known as residual income
Portfolio income, otherwise known as capital gains income
Within these three different types of income are various sources of income. The source of income is how you earn money. In keeping with the previous example regarding wages and salaries, working a job is a source of income specifically, the type of income is active income.
Let's take a closer look at the three different forms of income and examples of income sources within each category.
Active income is income earned from working. This can come from a full- or part-time job. It could also come from any self-employment business income earned from freelance side hustles.
Active income is one of the most straightforward and predictable ways to earn income. Generally speaking, you know how much you’re going to be paid for the hours you work. You can track your gross income (before taxes) and net income (after taxes).
Granted, something could happen, such as losing your job. But compared to other types of income, active income is the most reliable.
Passive income is money that pays you money in the background for work you've done previously.
Examples of passive income streams include:
Owning a rental property in which tenants pay rent each month
Hosting a blog that pays distributions based on advertisements and web clicks
Receiving royalties from an online book sale
Passive income is a highly sought-after kind of income because it helps people reach financial independence. For instance, you may feel safer in your retirement plan if you know that you’re receiving rental income on a property you own, especially if you already paid off the mortgage. Passive income grants a steady income stream without having to do much work. Much of the work is done upfront. For instance, with a rental property, you may put in work to buy the asset and renovate it. From there, you merely need to worry about upkeep.
It's worth noting that passive income is taxable income, and you’ll need to declare it on the tax returns you file with both the federal government as well as state and local governments. The amount you pay in taxes depends on how you’re earning money. Consider speaking with an accountant to determine how passive income will impact your income tax rates.
Portfolio income is essentially investment income. It's money that your investments generate, such as a stock that pays dividends. A dividend stock pays out money to stockholders on a predefined basis, typically every quarter or year. You can cash out these dividends or reinvest them.
It's important to note that, aside from the dividends scenario, portfolio income is only generated when you sell an asset. For instance, let's say you buy a stock for $10. It increases to $20 on the stock market. Though the value has increased, you haven’t received any money in your pocket unless the stock pays dividends. If you sell the stock for $20, you will generate income.
Your retirement accounts, like a 401(k) or 403(b), pensions and IRAs, would also constitute portfolio income. Again, you'll need to sell the asset before generating income.
Any other assets in your portfolio could technically serve as portfolio income. Real estate is a perfect example. If you buy your home for $300,000, pay off the mortgage and sell your home for $500,000, you'll have generated $200,000 in income. But again, you need to sell the asset to recognize this income.
Because you need to sell the asset to recognize income, portfolio income is less predictable and isn’t viable as a short-term solution. There can be market fluctuations that determine the value of your assets. Additionally, tax rates can vary depending on when you sell the asset. If you hold the asset for more than a year, you’ll pay long-term capital gains taxes. But if you hold it for less than a year, you’ll pay taxes based on your income tax bracket.
This income can come with its own laws, restrictions and fees. Consider consulting with a financial advisor before exploring portfolio or passive income.
Why is it important to have different types of income?
Diversifying your income sources can put you on the path toward financial independence. You’ll begin generating passive and portfolio income streams by investing in assets and other ventures. Both of these allow you to make money without doing as much work.
Multiple income streams can also help protect you during uncertain times. For example, if you lose your job, you may still be able to make some money from another source of active income, like a side hustle. Or, perhaps you’re making enough passive income to hold you over until you secure new employment.
This can also help keep you out of debt. If you only have one source of income, you’re reliant on it to pay your bills. If you lose that source of income, you may need to take out a personal loan or credit card to cover expenses. Doing so can cause you to be charged interest, and missing payments can harm your credit score.
How can you start building different income sources?
There are multiple ways for you to start building different income sources. Take time to research different income streams. You can also pick up a side hustle to earn more active income. Perhaps, over time, you can build your side hustle into a small business so that your active income becomes a form of passive income.
Also, you may want to talk to a financial advisor to focus on your wealth management strategy. You should consider having a rainy day or emergency fund in a savings account before you start investing. If your company offers it, do what you can to take advantage of any retirement perks that are offered, such as matching 401(k)s.
Having different types of income can set you on the path toward financial success
Taking advantage of different types of income can put you on the path to financial freedom. Not only can diversifying your income help during times of uncertainty, but it can also potentially keep you out of debt. This, in turn, offers flexibility for you to reach other savings goals.
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