If you have ever held a job, you’re familiar with the most common form of income, which is earned income. You may also be familiar with passive income and portfolio income. These are the three categories of income. Below we will describe what these categories are and give examples of each, but before we jump ahead, we will discuss the importance of knowing these different types of income.

THE IMPORTANCE OF KNOWING DIFFERENT TYPES OF INCOME

Plain and simple, income is the money you receive. How you receive that income will determine the category it falls under. We live in a society that requires us to earn income to meet our needs, wants, and ability to survive. Knowing the different types of income is very important in a society where income is paramount to survival.

Knowing that there are different types of income is empowering. It gives you the ability to recognize opportunities where others may overlook them. While others may feel stuck in a position earning money one way, you are free to explore other opportunities. This will give you the opportunity to pivot in your career if necessary, start a new venture, and even more.

Many successful entrepreneurs pursue entrepreneurship after they are fired or laid off. Instead of pursuing similar types of income, they went out and pursued other types. Being let go from a career that you have invested time and energy in can be demoralizing, but knowing there are other options out there can keep you from staying demoralized. 

Also, knowing the different types of income can help you in your tax strategy. Not all income is taxed the same, and knowing this can help you come up with a strategy that will help you reach your financial goals. Below is a list of the three categories of income:

ACTIVE/EARNED INCOME

Our first category of income is active/earned income. It is the most common form of income, and as the name suggests, it takes activity to earn. Everyone who has a job is receiving earned or active income. Earned income is exchanging labor, time, service, or some expertise in exchange for money. The structure of earned income can take several forms such as:

  • WAGE

Wages are determined by a pay rate (usually a dollar amount per hour) multiplied by how many hours worked–this is usually on a weekly or biweekly (two weeks) basis. Wages are usually paid to skilled and unskilled workers, but not exclusively to them. 

  • SALARY

Salaries tend to be a fixed amount paid regardless of how much or how little a person works. It is usually measured on an annual basis. It is then broken down in increments according to the individual pay schedule frequency. 

  • COMMISSION

Commissions are often found in sales when an individual completes a task. That task could be to sell a certain amount within a day, week, or month; then they will receive a certain percentage of sales.

  • BONUS

Bonuses are usually given at the end of the year and are determined by company and/or employee performance. Bonuses also can be an incentive to recruit new hires to a company, also known as a sign-on bonus. 

  • FREELANCE/CONTRACT

Individuals who earn income through freelance and contract work are paid to complete tasks. The main difference between freelance and contract is duration. Contractors are hired to complete larger, more complex tasks that require more time.

  • TIPS

Tips are paid most often in service-based industries. Industries such as deliveries, restaurants, and hospitality are common industries where you will find tips. Tips are money given by the customer directly to the employees in various amounts. There are culturally suggested amounts, such as ten to twenty percent, but it is up to the customers how much they want to tip.

  • MIX

There are many industries where the income structure is mixed. There are industries that pay wages & commission, salary & commission, and more. It is not unusual to see a mixed-type income structure, especially in performance industries. In the restaurant business, employees are paid both wages and tips. 

PORTFOLIO INCOME

Portfolio income is income earned through investments. Different types of investments and what you do with that investment will provide different types of income. 

  • INTEREST INCOME

Money that is paid out for being held in financial instruments is called interest. Interest is determined by the financial institution offering the financial instruments. The amount is structured by multiplying a percentage of the money held over a period of time. This could be two percent monthly or yearly of the money invested. Examples are the interest you receive from CDs, savings accounts, and bonds.

  • DIVIDEND INCOME

You receive a dividend when you invest in stocks. When a company has passed the growth stage and is in the mature stage, instead of reinvesting their profits back into the company to grow, they distribute the profits to shareholders. Not all mature companies pay a dividend. Also, dividends can come and go. It is not unusual for a company to announce that they are not offering dividend payments anymore. They can also increase and decrease payments.

  • CAPITAL GAINS

Capital gains is the appreciation in an asset that is realized when sold. For example, if you purchased a house for $200,000 and it appreciated to $250,000, the moment that house is sold, any amount you receive over the purchase price is capital gains.

  • PROFIT INCOME 

Profit income is determined after a business subtracts all its expenses from its revenue. If the number is positive, then there was a profit; if it is negative, then there was a loss. Profit income does not only pertain to businesses, but it also pertains to individuals that work for themselves, such as small business owners, freelancers, and independent contractors.

PASSIVE INCOME

Passive income is income received from little or no activity. There is usually an initial investment or activity that takes place in the beginning, which requires little activity to maintain and no further investment going forward. Some examples are below:

  • RENTAL INCOME

Rental income is a great example of passive income. This could be the renting of commercial and residential properties and the renting of equipment. If you’re part of the everyday activity of these activities, then it is not passive income, but if a manager or a management company is handling the day-to-day activities, then the income you receive is passive. This is true if you are the owner of the properties or equipment.

  • LIMITED PARTNERSHIP

Limited partners can also be silent partners who are part owners of a business, but they are not responsible for the day-to-day activities. They may have contributed money in the beginning of the business or decided to limit their role in the business due to personal reasons. Whatever the reasons may be, limited partners and silent partners receive passive income due to their lack of involvement.

  • ROYALTY INCOME

Royalty is the income received by one party from another party for the use of their property. These properties tend to be intellectual properties such as artistic work, design, music, books, and more. Royalties may be determined by percentage of sales or quantity of units sold. 

FINAL THOUGHT

By now you should realize that income is not just limited to earned income or just a job or profession. There are many different types of income, and they mainly fall under a few categories. That category could be earned, portfolio, or passive and can be realized by continuous activity or an initial activity followed by no further activity. 

Many of the different types of income are grouped differently due to the tax code. Capital gains, dividends, and interest income can all fall under the category of passive income, especially if you’re not part of the day-to-day activity. They are in different categories based on how they are taxed. Not only are some incomes taxed differently, some incomes are not taxed. Income that is less than a certain amount and VA disability income is not taxed. When thinking about income, it is important to keep in mind that how the income was obtained will determine the type of income it is and how it may or may not be taxed. The information above should help you better understand income and all the different types.