The Three Types of Income

Introduction

Immediately upon graduation from college, my mindset was to get a job with a nice salary. At that point in time, I only thought that your earned income or your salary is the only thing that matters when it comes to income and personal finances. Boy was I wrong. I remember hearing about how much some of my friends made and solely focusing on increasing my salary. Although important, it is only one side of the triangle. Now when people ask how much money I make, although the question becomes rarer as you get older, I smirk and I ask “Do you mean what is my earned income?” I usually receive a puzzled look and then I begin my explanation. There are three types of income: earned, portfolio, and passive. Those that are serious about personal finance pursue and possess all three.

Reading “Rich Dad Poor Dad” by Robert Kiyosaki was fantastic and it first introduced me to the concept. Upon reading the information, I pursued it through further research and confirmed that this is indeed a strong concept shared by an abundance of wealthy individuals. In order to establish financial independence, one must be aware of these three types because all of them contribute to your net worth; which equates to your personal finance bottom line.

Earned Income

This type of income refers to your salary or wages earned from labor. This is the most common type of income. Sadly, for most, this is the only type of income. It is the kind you receive via paycheck from your employer. A strong earned income is very important. However, one must be careful if he or she is solely relying on this one source of high income because if it is lost, the individual will more than likely be in serious trouble. This also reinforces the notion why one must have a safety cash buffer in case of job loss.

Earned income is usually what individuals rely on to pay for life necessities. For most, it is the main source of income that arrives into your bank account on a reoccurring basis.

Portfolio Income

One of my favorites. Portfolio income is the income derived from financial or paper assets such as stocks and bonds. Hopefully, an individual will have a solid financial portfolio of paper assets in order to generate wealth. Within the portfolio, referenced paper assets grow due to market fluctuation and as a result increase in value. These assets are also sold for profit and realized within the portfolio as capital gains. Dividends are also paid from paper assets that as a result increase value.

It is so very important to get a strong portfolio of paper assets generated early in life. It really is a beautiful thing. While you are working and living out your life, these paper assets will usually continue to grow. The earlier you get started the better because one can witness what Einstein refers to as the eighth wonder of the world: Compound Interest. This interest generates at an increasing rate the longer it is held. Thereby increasing your portfolio income. One of the best things about portfolio income is how easy it is. Of course, one can make it complicated. However, if an individual just simply socks away hundreds of dollars a month into a well-diversified portfolio, modern portfolio theory suggests that you can’t lose. Get started on this one!

Passive Income

Perhaps the most difficult income class to obtain is passive. At the most basic level, passive income is money earned with little or no effort. It is the income earned from something in which the receiver is not a direct participant. An example would be income collected from real estate properties or from an already established business or LLC. This is considered by many to be the key to financial freedom. It is often said that if you don’t make money while you sleep, you will never be rich. Granted, this same token can be applied to portfolio income.

This is a difficult class to obtain because it usually requires either a great deal of capital or labor in order to generate substantial returns. For example, establishing a solid income stream from rental properties or stock dividends requires a great deal of cash (capital). In addition, it would require a great deal of time or labor to establish a business or LLC to generate lucrative returns. Again, this is why it is considered to be the Holy Grail. To get paid for labor not incurred is a beautiful thing.

Final Thoughts

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In order to become financially independent, all three classes of income are necessary. Earned income is usually necessary for life’s expenses such as shelter, food, and transportation. It is the take home pay for you labor and skill. Portfolio income is the income derived from paper assets. Again, it is very important, especially at an early age, to establish a strong portfolio income. Usually, the portfolio will continue to grow over a lifetime and constantly generate returns for your bottom line.  Passive income should be a goal for everyone. If you are capable of establishing two or three passive income sources that are substantial, you are well on your way and I salute you.

So bottom line, don’t just think of income as the money made at your job.

Redefine

-James