The 3 Different Types of Income and Why They Matter

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Types of Income

There are many different ways to make money, with countless options, from a traditional job or side hustle to investments and passive income. Understanding your options and how you can combine several of them to build multiple streams of income will help to improve and stabilize your financial situation.

This article covers the different types of income, what they are, and how they can impact you.

Why Your Types of Income Matter

Each type of income is generated differently. We all have a limited amount of time available for work, but thankfully some income types don’t require time or effort. When you understand the different income types and how they work, you can maximize your total income by strategically creating multiple income streams.

Diversifying your earnings helps to protect you financially if one stream dries up – whether due to an economic downturn or other unforeseen circumstances. And while it may require some initial effort to set up additional revenue streams, the long-term benefit is undoubtedly worth it.

The Different Types of Income

Now, let’s look at the specific types of income and the details of each.

1. Earned Income

Earned income (sometimes called “ordinary income”) is the money you make from working. This includes your salary or wages, bonuses, sales commissions, tips, and freelance work. It’s the most straightforward way to make money, and it’s the type of income most of us rely on.

If you work as an employee of a company, your salary or wages are earned income. And if you’re a contractor or freelancer, your compensation is also considered earned income. Regardless of how you get paid, it’s earned income if you’re directly compensated for your work.

Of the three primary types of income, earned income is generally the easiest to get started, as long as work is readily available. The downside to earned income is that it’s limited since you can only make money while actively working and having a job. With limited hours in the day and physical limitations that prevent us from working endlessly, there’s only so much work that one person can do.

2. Portfolio Income

Portfolio income is the money you make from certain investments. This investment income includes dividends from stocks and mutual funds, interest payments from bonds and CDs, profits from real estate investment trusts (REITs), and other income from investments in your portfolio.

Unlike earned income, portfolio income doesn’t require your time or effort to generate. Once you buy an asset within your investment portfolio, it can generate money with minimal input or maintenance. Therefore, portfolio income has greater potential for growth than earned income — although greater risks are involved since investments may not always perform as expected.

See our list of income-producing assets for some ideas.

Interest Income

Interest income is one of the most common types of portfolio income. It’s money you generate from the interest that accrues on your investments, like savings accounts, money market accounts, CDs, and bonds. Interest income can also come from loans you’ve made to others.

Interest-earning accounts often have low risk compared to other investments, but they typically offer lower returns than stocks and mutual funds (over the long term). However, this type of income can be steady and predictable.

If your priority is long-term growth, your portfolio probably won’t include many of these investments. But they can be effective when income is more important than long-term growth.

Dividend Income

When a publicly-traded company generates a profit, it can reinvest that money into the business or pay dividends to shareholders, or both. As a stock owner, you can generate significant income by building a portfolio that includes stocks of companies that regularly pay dividends.

You can also earn dividends from other investments like mutual funds, exchange-traded funds (ETFs), REITs, real estate crowdfunding, etc. Dividends are typically paid quarterly, but some stocks and ETFs may pay monthly or annually.

Related reading: Living Off Dividends

3. Passive Income

A passive income stream is any type of income that doesn’t require active work or effort. This can include rental income, royalties, social security benefits, and money made through a business or investment that doesn’t require your time.

Passive income can generate significant amounts of money over time, provided you make wise investments upfront. And because there’s no ongoing effort required after the initial setup, this type of income can provide steady streams of cash with limited work.

Most types of passive income require a financial investment, but some passive income ideas can generate money without any upfront investment.

Now, let’s look at some of the most common ways to generate passive income.

Rental Income

Rental income is money generated from renting out a property. This can include a house, vacation property, commercial space, and more.

There are also some less traditional options like renting a camper, RV, truck, car, or storage space. See our list of things you can rent out for plenty of ideas.

If you own rental properties, you can generate a steady cash flow each month. And on top of the rental income, most property values appreciate over time.

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Business Income

If you have an ownership interest in a business that doesn’t require your time or effort, that would qualify as passive income. For example, you could be an investor or silent partner in a privately-owned business, and you may be paid monthly or quarterly.

There are also many low-maintenance businesses you could set up and run to generate passive income.

Royalty Income

Royalty income is money generated from selling or licensing intellectual property you own. This could include books, music, films, software, and more.

You can create your own products or services to generate this income stream, such as writing a book or creating an app. Another option is to invest in assets that generate royalties.

The Truth About Passive Income

Although we call it “passive income,” most of these income sources are not 100% passive. Instead, they may require a small amount of your time, or your income may be uncorrelated to your time or effort.

For example, owning a low-maintenance business like a self-serve car wash is often considered passive income. In reality, you’ll need to put some time and effort into the business, but it will be minimal compared to other types of businesses.

The key is that your income is not based on the amount of time or effort you put in. You may generate a significant income with just a few hours of work. It’s also possible to outsource most work rather than doing it yourself.

How Many Income Streams Do You Need?

There’s no exact number when it comes to creating multiple streams of income. Some people focus on two or three, while others generate five or more.

The key is to create enough portfolio and passive income streams that you have a significant amount coming in each month, even if your primary source of income goes away.

You may use these non-active income sources to supplement your earned income, which increases your overall income. Or you may be able to generate enough portfolio and passive income that you don’t have to rely on earned income at all.

Ultimately, the goal should be to create enough passive income streams so that you don’t have to worry about money and can enjoy life without money worries.

How to Move Away from Earned Income

If your goal is to move away from earned income and become financially independent, you need to create multiple streams of passive income.

Dividend-generating investments like dividend stocks and real estate crowdfunding are an ideal starting point. You can see our Dividend Aristocrats list to find some stock ideas, and we recommend Fundrise for passively investing in real estate.

Next, consider investing in rental properties or low-maintenance businesses that generate steady monthly cash flow.

Find the types of investments you’re comfortable with and constantly add to your portfolio by saving and investing as much as possible. For now, you can reinvest dividends if you don’t need them for living expenses. This will help to grow your portfolio faster, and then you can take the dividends as cash later on.

Frequently Asked Questions

What’s the difference between “active” and “passive” income?

Active income is income that you must actively work for each month. Examples include salary, wages, and tips. Passive income is money that comes in without any effort or active work on your part, such as portfolio income from investments or business income from a self-serve car wash. The key difference is how much time and effort you need to generate the income.

What types of income are taxed?

All types of income are subject to income tax by the IRS, including earned income, portfolio income, business income, and royalty income. There may also be state-level income tax, depending on where you live. However, not all income is taxed the same. Speak to an account or tax professional to get advice relevant to your personal situation, location, and taxable income.

How can I make passive income with no money?

It’s possible to make passive income with no money, but the options are somewhat limited. You can use passive income apps that generate money on autopilot. You can also take advantage of signup bonuses and then invest that money.

How can I make passive income with money?

You can invest in dividend stocks, rental properties, and other investments that generate passive income. You can also start a business or create digital products like e-books and videos for sale.

Final Thoughts on Types of Income

By understanding the different types of income available and how they impact your financial situation, you can build multiple streams of passive income that will help create more financial security and freedom in your life. Start small with low-effort investments like dividend stocks and real estate crowdfunding, then slowly increase your efforts until you can generate enough passive income that you no longer need to rely on an active stream of earned income.

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