Three Types of Income
Financial theorists and practitioners all seem to agree on one basic principle, i.e., diversification is the most important tool which helps mitigate risks. Most investors agree on the importance of diversification while making investments. However, they do seem to be on the fence when it comes to diversification while earning income.
Some of the biggest financial experts in the world, including Warren Buffet, have advocated the need for having multiple sources of income. These multiple sources increase the chance of a person living a wealthy life. In this article, we will have a closer look at the three types of income as well as their impact on the financial health of a person.
Income #1: Earned Income
This is the primary source of income. For most people in the world, this would include salaries or the profits earned from their business. The problem with salaries is that they are can be difficult to increase. The growth of salary happens at almost a fixed rate. Also, if a person wants to increase their salary income, they often have to work more hours. As people get older, the possibility of increasing the number of hours reduces. This is because the level of their physical fitness decreases. This also means that their responsibilities towards their family and society take up more of their time. Hence, it has been observed that salaried income reaches a plateau when the person is in their middle ages. Post a certain age, salary increments only cover the rate of inflation.
Also, it needs to be noted that salaried income is one of the most highly taxed sources of income in the world. In most developed nations, salaried income is taxed at almost 50%! This means that once a person crosses a certain income threshold, their motivation to earn income also reduces because of the high rate of taxation.
Income #2: Investment Income
This is the income that is generated by selling investments that were made earlier. In simpler words, this represents an increase in the value of the investment or capital gain as it is known in common terms.
For instance, if a person buys shares and sells at a higher price or if they buy a house and sell it for a profit, the difference is called a capital gain. This income has no relation to the number of hours worked. Also, this income is not received periodically. It keeps on accruing over a period of time and is paid out when the investor decides to liquidate it.
Also, this type of income is more tax efficient as compared to earned income. This is true only if the investments have been held for a long period of time. Most countries in the world separate long term capital gains from short term capital gains and tax them at a lesser rate.
Income #3: Passive Income
Passive income is another important source of income. It shares the characteristics of earned income and investment income. Just like earned income, it is paid for every period of time. However, the quantum of income does not depend upon the number of hours invested. Rather, it depends upon the capital invested. This is where passive income is similar to investment income.
Typical examples of passive income are rent, interest, and dividends, which are paid by shares and debentures. The taxes on this type of income are also less as compared to the earned income.
Some incomes like dividends are totally tax-free in the hands of the investor. For other incomes like rent, there are tools such as depreciation, which can be used to lower the income and, therefore, the tax payable.
So, the bottom line is that the three types of income have different characteristics. These different characteristics are suited to different stages of life. A good understanding of these sources of income is important to increase an investors wealth over their lifetime.
- The earned income is the root of all wealth. This is particularly true in the early stages of ones career. This is why it is important for a person to consciously increase their earned income in the early stages of their career.
- However, they should not increase their expenses in line with their income. Lower expenses with higher income would create a surplus of funds that can be invested.
- These invested funds should be used to generate the second source of income, i.e., investment income. Since investors are earning off of their primary source of income, they can afford to invest for long periods of time using tools such as equity. Since equity offers the highest rate of growth, this can help to maximize the growth potential.
- Next, as the age of a person increases, more and more money should be moved out of equities towards investments such as fixed deposits and rental properties. This will help provide a more stable source of income when the investor finally retires, and the earned income stops.
Ideally, every working person should have some knowledge about how the different types of income can be used to generate holistic wealth. However, it is surprising that many people do not focus on generating the second and third kinds of income and hence are not able to make optimum utilization of their earning potential.
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