Types of Income and How One Should Define Them

If I ask someone on the street how they define income, they’d probably stare at me for a few seconds and then get on with their day. The answer is so obvious that the question appears silly, isn’t it? Whatever you earn is your income, right?

types of income

Well, not really.

One important thing you need to consider is tax. Tax deducted income and gross income are different. It’s basic knowledge and everyone knows it. So let’s delve into more complex areas.

There are three types of income. Here’s how each of them is defined.

Active income

Active income is basically earning money by rendering services. This is the most common type of income. Everyone who is employed is making money from an active income source. When they receive salary cheque every month or money is credited to their bank accounts, it qualifies as active income.

By income most people understand active income. Some economists believe that people’s inability to consider other types of income as legit as active income is somewhat responsible for the lack of economic growth all around the world. Is there some truth to it? Maybe. If you only depend on active income, the chances of growing it is slim, for obvious reasons. You can’t do two 9 to 5 jobs at the same time, can you?

The shortcomings of this type of income – the biggest shortcoming being the lack of flexibility – lead people to look for other income options.

The next choice in this list, also the second best earning option for most wage-earners is

Passive income

Any type of income where the income earner is not actively involved is passive income. Examples of passive income include but are not limited to income from rental properties, ancestral properties, interest earnings from savings in the bank, earnings from royalties on book sales, etc.

Passive income is taxable in the United States. The tax rate, however, is a bit confusing as the rate is bracketed and it doesn’t accurately separate passive income from other income types that are not active. Just like normal income, passive income is taxed depending on how high or how low is the income. Also, ordinary passive income is taxed at a rate between 10 and 39% while for earnings made from the capital market, tax rates are 0%, 15% and 20%.

In 2019, it’s more than essential to earn from passive income sources. Invest in rental properties or put money into a savings deposit scheme that offers high interest to customers. If you are creative, write a book or a light novel and publish it on an online marketplace. These are all excellent ways to make more money by working smarter, not harder.

The third type of income is called

Portfolio income

Portfolio income is a subset of passive income. Gains one makes from stocks, bonds, mutual funds, dividends, etc are portfolio income. Normally, income made from the capital market is considered portfolio income. Some day traders, however, would beg to disagree that capital market gains are portfolio income as they are proactive people and have control (albeit limited) over what they earn.

The thing is that most people shy away from investing household savings into the equity market. The most popular route through which money is flown into the equity market is mutual fund. Next is long-term equity investment for dividend gains. But day trading or F&O trading is still an esoteric territory. True, these segments contain significant risk but as the saying goes, where there’s risk, there’s a reward – people need to understand that and learn to manage risks so that they could make portfolio gains.

There are risk-free ways of earning from portfolio investments. Treasury bonds are less risky. The reason treasury bonds are considered safe is that they are stable, these bonds attract investment from overseas investors and also from other countries. US treasury bonds are considered the safest as Japan and China hold a significant percentage of them.

What type fits you?

If you are in a stable job, you already have an active source of income. You can take time and decide whether you want to earn money from passive sources or take a nosedive into the equity market, or try both.

If you are a retired person, you probably don’t have much interest in active income. Consider investing in the stock market. Look for stocks that have in the past bought back their own shares. It is called buyback and indicates that a company has strong fundamentals. Dividends are another indicator of a company’s strength and weakness. Hire a financial consultant if you are not too comfortable in these areas. If you are someone in their 30s or 40s, acquire new skills. Having skills is essential when making a foray into new domains that can lead to passive and portfolio income.

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