Most people think that the only way to earn money is to go to work, sit at a desk for 8 hours, come home, and get a check deposited into your account two times a month. It’s a cyclical lifestyle. And it can be a great way to get started earning more. However, that’s definitely not the only way to make ends meet, and if you’re chasing financial independence, that might not even be the best or most efficient way to earn cash.
But that’s not the only kind of income. There are actually three types of income you can earn. They are earned, or active, income, Portfolio, or capital gains, income, and passive income. All three should be part of your plan to retire early.
1. Earned Income / Active Income
Earned income, also called active income, is the most common type of income. It’s the income that we gain from a contract job or W-2 work, although there are other types of earned forms of income but they’re not as common. We’ll go over those in a second.
This kind of income is one of the most surefire ways to generate income because it’s transactional between you and your employer based on a contract generally. You do work, and you get paid. If you don’t get paid, there are means to retaliate and make sure that you get the money you need. It’s safe. You can get a lot of bread if you get a high paying job.
Examples of Earned Income
The most common examples of types of income that you work for from your day job. If you work somewhere like Starbucks or at a bank, that’s income that you earn. It’s income that you received by doing something. Examples of earned income include:
- Working as a contractor or freelancer
- Working as a consultant
- Working as an hourly employee
- Working as a salaried employee
- Working any odd jobs (Babysitting, mowing lawns, etc.)>
- Most business income, such as running a website
Active income can also come from one-off events, like garage sales or selling things on Craigslist or taking online surveys. There are tons of unconventional active ways to earn cash outside of a traditional work environment. Anything that you’re actively doing in exchange for money counts as active or earn income.
Pros vs. Cons of Earned Income
Earned income is generally steady, the only exception to this is if you choose to make money using one of the more unconventional methods. But generally you know that if you show up to work, put in the hours, and do good work, there will be a solid payout. You can make lots of money quickly depending on what kind of job you choose. But even if your job doesn’t pay well, small increments of money saved up over time adds up to a lot.
And it’s great at the beginning stages of financial independence to have any sort of solid income. It gives you a jumping-off point and something to build off of.
The more time you give up, the more cash you can make. But eventually, your time is going to be worth more than you’re being paid, and only having earned income doesn’t set you up well to make that transition.
Additionally, it can be harder to grow your income potential. You have to fight for raises, and eventually, you’re going to top out of your pay scale or get to a point in your company where you might not want to climb the ladder anymore.
And, you don’t have control over your time. This is arguably the biggest drawback to earned income in a more traditional setting. Your clients or company dictates when things are due and where you should be. You don’t have as much control over your life while you’re earning income. Although some jobs, like freelancing and consulting, can be a good bridge between W2 work and FIRE, they still have deadlines and rigidity built into their structure.
Overall, though, manually earning your income is the easiest way to bring home the bacon. And it’s a great way to start the journey to financial independence.
2. Portfolio Income / Capital Gains Income
However, at some point, you aren’t going to want to rely just on earned income. It’s a great start towards growing the second type of income: portfolio or capital gains income. This is income that is created from investing in the stock market.
Examples of Portfolio Income
At it’s very basic, capital gain, or portfolio income, is the income you generate when you sell a stock for more than you paid for it. So if you bought a stock that costs $150 and then sell it when the market says it’s worth $300, you’ve made $150 on that stock, and the $150 is considered your capital gains.
Another form of portfolio income is dividends. Dividend income comes from owning a particular form of stock or fund. After an appointed amount of time, typically once a quarter, companies pay out cash dividends to their dividend stockholders out of their earnings during the quarter. It’s a great type of income to add to your portfolio to help diversify it and keep the cash rolling in.
Pros vs. Cons of Portfolio Income
Capital gains are a great way to start earning bread outside of your earned income. You take that new found moolah, invest it, and now your money is working twice as hard as you. This can be considered a drawback since it means you need to have means in order to access this kind of income. However, even a small amount in the market, over time, can make a large difference, and there are investing apps that help you get started for just $5.
Also, long term capital gains are taxed at a preferential rate if you’ve held the stock for a long enough period of time. This means that you’ll pay taxes at a lower rate than earned income, which can make it even more attractive as a form of accumulation.
3. Passive Income
Another form of income, and one that is highly sought after if you’re pursuing financial independence, is passive income. It’s also the broadest category because it encompasses a whole lot of diverse projects and ideas.
At its core, though, passive income is income that you earn without doing anything continuously. Some passive methods take some time to set up, but once the ball gets rolling, you don’t have to do anything, and the dough comes pouring in.
It’s highly sought after in the financial independence world because if you can earn money doing nothing, then that leaves you space and time to do other things, like taking that vacation you’ve always dreamed of. Or moving to Prague for a year. As long as your expenses are covered by passive income, you have the freedom to live the life you’ve always wanted to create for yourself.
Examples of Passive Income
Here are some of our favorite examples of passive income.
- Courses: Courses are an awesome way to make passive income. While they might take a lot of energy and creativity to set up, an online course can have massive rewards. Depending on who you run your course through, and what the terms and conditions are, you could have months where you make over $1,000. And you can create a course on anything that you’re interested in because chances are if you’re interested in it if there’s a market for it.
- Printables: Opening a printable shop on Etsy is another great way to earn passive forms of income. Create some worksheets, or coloring pages, or cool graphics, set up the shop, and slowly, the moolah starts coming in. It can be a great passive way to make some extra cash if you’re willing to do the work upfront.
- REIT: REIT is an acronym for Real Estate Investment Trust. They are a great way to invest in the real estate market without having to buy an entire property. Here’s our basic guide to REITs and how you can get started.
- Rental properties: However, if you do have a lot of cash to invest, buying a real estate property could be a great way to create passive income, especially if you outsource the property management to a company or contractor. You could choose to rent out the property to long term tenants, or use a service like Airbnb and use a short term renting model, depending on what works for you. It’s important to note, not everyone would consider rental income to be passive unless someone else managers the property for you.
The sky’s the limit in terms of creative passive activities. If you can come up with a sustainable model for passive income, then, by all means, chase that model.
Pros vs. Cons of Passive Income
Setting up a passive income stream allows you to have the flexibility you need to become financially independent. It’s one of the most powerful tools you can have. And, unlike using investments to generate income, you don’t need a lot of capital for some of the projects – just creativity.
However, it’s a lot more time-intensive than first meets the eye. If you want to create great products that people want, you will need to spend the time, energy, and effort thinking through what that looks like and how to actualize your goals. Then, you have to put in the hard work to create the product itself.
But ultimately, passive income is a great way to gain extra money without having to do continuous work.
How to Use Your Income to Build Wealth
In order to build riches, you want to use a combination of the three types of income. Start with earned income and start saving money. If you aren’t making enough to save any money, consider asking your boss for a raise, or finding work outside of a traditional 9 to 5.
You’ll want to make sure that you have a fully-funded emergency account, generally considered six months to a year’s worth of expenses, before you start seriously investing that earned income into the market. But once you have those cash savings in place, it’s time to start investing.
The first place to invest is going to be your tax-advantaged savings accounts. Maxing out your 401(k), IRA and other retirement accounts is a great way to save cash and prepare for the future, but that kind of investing will only take you so far.
The next question you need to ask yourself is how do you want to invest outside of those accounts. This will give you a multi-pronged route to creating revenue. Some you can access when you’re older, and some you can access before the traditional.
You could go the route of the market with its capital gains and dividends, or something else, like REITs or real estate property. Now would be a great time to sit down and picture your future life. You want to make sure you have a firm understanding of your why with investing. This is going to help you navigate through some of those tougher questions.
Once you’ve decided where to invest, create a long term investment plan. This is going to look different for every individual, but it’s the key to building long term, sustainable wealth.
After that, you can start to look at how to generate passive income. Ask yourself what you can create or fund that will allow you to not have to work for an income stream. Use that answer to help guide this part of wealth building. Any income that you can earn without actively doing work is income that you don’t have to save for retirement, so this is your fiercest weapon for financial independence.
Other Income Types You May Hear
Gross income: is usually considered the amount of money you receive before all taxes and other deductions including local and state taxes. This is usually easiest found on your pay statements. Any payments from unemployment compensation would count towards this, as it is still considered taxable income.
Adjusted gross income (AGI): can easily be found for W2 employees with no other business interests on their tax-return easily. Taxpayers will find their adjusted gross amount on line 7 of form 1040.
Unearned Income: Social security would be considered unearned income.
Taxable income: is generally defined as your AGI minus any deductions. Depending on whether or not you take the standard deduction, your tax bracket, filing status, and other factors your taxable income could cause your tax bill to vary drastically. This is true for both your federal income tax as well as your state income tax tables.
Related: Check out our article explaining IRS Tax Forms
For additional information visit the internal revenue service website. They keep the most up to date information on longterm capital gains tax, shortterm capital gains tax, social security benefits, income tax rates, ordinary income tax rates, and municipal bond interest gains tax rates.
Use The Three Types of Income To Achieve Financial Independence
Between earned income, investment income, and passive income, you should be able to build a diverse set of income streams that will allow you to retire early. It might take some time, but the payoff is definitely worth it.
Building wealth is incredibly crucial to having a good life and attaining financial independence. It gives you the freedom to create that life you’ve always dreamed of.
Take a moment to sit down and create a plan that utilizes the three types of income streams, and don’t forget to tell us about it in the comments. How are you planning to reach financial freedom?
Samantha uses her BS in Finance and MBA to help others control their finances through budgeting, saving, investing, side hustles, and travel hacking. Due to following the FIRE Movement’s principles, she was able to quit her high-stress job in the financial services industry in July 2019 to pursue her side hustles. She is now a full-time entrepreneur, freelancing coach, and blogger.