3 Sources Of Income and Their Importance

Last Updated on May 24, 2023

I’m sure you know by now that money does not grow on trees, so where does it come from? Especially in today’s gig economy, you might be surprised to learn that there are many different sources of income.

Some sources of income may be obvious, such as salaries. But you may not have thought about other sources of income. Understanding the big picture helps with financial management.

It is no secret that even some of the world’s greatest financial experts, including Warren Buffett, advocate the need for multiple streams of income. These diverse sources of information increase a person’s chances of living an abundant life. This article takes a closer look at three types of income and how they affect a person’s financial health. Meaning how they can build wealth if they want to

What is Income?

Income is what you can put in the “plus” or “income” column of your budget. usually measured in bars. Your salary may be the first source of income that comes to mind. 

However, other types of income include:

  • Earn tips and commissions on top of regular wages and salaries.

  • Sale of goods or provision of services for profit 

  • Earning interest, dividends, and capital gains on investments

  • Win Prizes, Awards, and Scholarships 

  • Receive a gift, benefit, or inheritance

  • Receive government benefits and tax refunds.

  • Withdrawing from retirement or pension funds

Types of Income

1. Earned Income

This is your main source of income. For most people in the world, this includes salaries and profits from the business. The problem with salaries is that they don’t go up. Salary growth is fairly constant. People want a raise, but they often have to work more hours. As you get older, you are less likely to increase the number of hours. This is due to their reduced health level. This also means that their responsibilities to family and society take up more time.

Therefore, it has been observed that salary income peaks in middle age. After a certain age, salary increases only to cover inflation.

It is also important to note that dependent income is one of the most taxed sources of income in the world. In most developed countries, salaries are taxed at almost 50%. This means that above a certain income limit, there is less incentive to generate income due to higher tax levels.

2. Capital Gains

This is the proceeds from the sale of previous investments. Simply put, this, as it is colloquially called, represents the increase in value of an investment or capital gain. The difference is called capital gain. This income is disproportionate to the number of hours worked. Also, this income is not regular. It continues to accumulate over a period of time and is paid out when the investor decides to liquidate. Additionally, this type of income is tax-efficient compared to earned income. This applies only if the investment is held for a long period of time. Most countries in the world separate long-term and short-term capital gains and tax them at lower rates.

Read: What is a Real-Life House Flipping Success Story?

3. Passive Income

Passive income is another important source of income. It shares the characteristics of earned income and capital gains. It is paid in the same manner as earned income for each period. However, the amount of income does not depend on the number of hours invested. Rather, it depends on the capital invested. Passive income is similar to capital gains. Typical examples of passive income are rent, interest, and dividends paid by stocks and bonds. Taxes on this type of income are also lower compared to earned income. Some income, such as dividends, is completely tax-free in the hands of investors. For other income, such as rent, there are measures such as depreciation that can be used to reduce your income and therefore the taxes you have to pay.

Here are the advantages and disadvantages of the three types of sources of income

Benefits of Earned Income

Earned income is suitable for people with low financial IQ. The formula is very simple. I do X work, and you pay me Y. In a good economy, doing your job well is very stable, and you can expect a certain amount of money to flow into your pocket each month. In many cases, if you do an excellent job, you can get a raise every month and put more money in your pocket. Nearly everyone in the world believes that high-paying jobs are the safest. Rich Dad believed otherwise.

Disadvantages of Earned Income

For many people who earn money from their jobs, just covering their basic monthly expenses is enough, leaving little or no money left to invest. The adage “live to work” describes their status. If you want to make more money, you have to work more hours, either through a full-time job, a part-time job, or freelancing. But even for highly paid employees, earned income is very risky. If the economy crashes or your company does badly, your job can quickly disappear. Unfortunately, millions of people discovered this during the COVID crisis, and many of those jobs didn’t come back.

And perhaps worst of all, earned income is taxed the most. More on this later in this article.

Benefits of Capital Gains Income

Capital gains income can help you make a lot of money in a short period of time. When the economy is on fire, it can seem like a no-brainer to buy low and sell high. Or, with insider information from people like Reddit’s trader, who pushed GameStop’s price up a while ago, Rocketship can be pinged.

Disadvantages of Capital Gains Income

Being speculative, it is difficult enough for experienced investors to consistently profit from portfolio returns. Therefore, following the herd is extremely dangerous, especially for those with a low financial IQ. As you get into the late game, many can be slaughtered by those who raise their prices, as they did at GameStop.

Capital gains returns are also economically dependent. Many people who flipped their homes in 2008 were rudely awakened when the entire housing market collapsed almost overnight. And because a home is a slow-moving asset, most people don’t sell it in time to recoup their losses. And just like income, you pay very high taxes on your portfolio income, even if you make a profit.

Benefits of Passive Income

Perhaps the greatest advantage of passive income is that once you own the property, you will have cash flow whether you are working or not. More and more money is flowing into your pocket, so you can do other things. Find more cash flow assets.

Even better, you can use Cash Gain to get even more cash. And unlike Pincome, you still own the original asset even if you use cash flow earnings to buy more cash flow assets. It’s a compound effect. And surprisingly, unearned income has the lowest taxable income. It’s as if the government wants you to invest this way. Passive income is one of the most easily enjoyed sources of income.

Disadvantages of Passive Income

Successful passive income investing requires a high financial IQ and perseverance. These are two things most people in the world don’t have.

Most people have low financial IQs. It’s not necessarily their fault, but the same people who were told to go to school, get a secure job, and invest in the stock market for the long haul have a bad house. I was told… it’s an asset. There was a belief that your home would always go up in value.

Only recently (2008) did everyone realize that the belief was not true. Some people have seen the value of their homes cut in half almost overnight. What these homeowners realized was that their home was a liability, not an asset.

Assets put money in your pocket, but liabilities take it out. Take another look at your home. Even if you own a home, you still have to pay maintenance costs, property taxes, and utilities. If your home is an asset, it will bring you money, not take it away from you.

In short, the three types of income have different characteristics. These different traits are suitable for different stages of life. A good understanding of these sources of income is important for investors to grow their wealth over a lifetime.

  • Income is the root of all wealth. This is especially true in the early stages of your career. Therefore, it is important to consciously increase your income early in your career.

  • However, it would help if you did not increase your spending in proportion to your income. As your income increases and your expenses decrease, you have surplus funds that you can invest. These investment funds are used to generate a second source of income: 

  • Investment income. Investors benefit from their primary source of income, so they can afford to invest in commodities such as stocks for the long term. Equities offer the highest growth rates and thus help maximize your growth potential.

  • Then, as you get older, you’ll need to move more and more money from stocks to investments like fixed deposits and rental properties. This helps provide a more stable source of income when the investor eventually retires and their earned income is gone.

Before you go…

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