A key point to building your wealth revolves around this critical question: what is portfolio income?
Your income is the engine that drives the amount of money you will have in life. In this article, I will explain the 3 different types of income. And why the third type, portfolio income, is so important to have more money.
Raise your hand if you would like to have more money.
Once I understood portfolio income, I made better decisions about jobs, work, money management, and life. You can too!
Also, knowing the answer to the question “what is portfolio income?” helped me to build my finances faster. And, retire earlier.
So, let’s get started by identifying the 3 types of income.
What Is Portfolio Income vs. Earned Income vs. Passive Income
I think there is a lot of confusion in the personal finance community about different types of income. By knowing the 3 types of income, you will better understand what portfolio income is.
Here are 3 types of income. Let’s understand them and answer these questions in the following order.
- What is earned income?
- What is passive income?
- What is portfolio income?
What Is Earned Income?
Earned income is also known as active income. There are 2 ways to make earned income.
First, a person earns income through wages from a job. In other words, you work for someone who pays you.
Second, earned income can also come from making money through business ownership. Essentially, you own AND run a business.
Before we go on, let’s clarify business ownership. You probably know, I make money from dividends by owning stock in companies. Therefore, I own a piece of those businesses. But, that does not qualify as earned income.
Why not? Because I do not actively participate in the businesses in which I own stock. So, only income from a business you actively participate in qualifies.
Examples of Earned Income
It may seem obvious from the definition, but to be clear, I will lay out a few examples of earned income.
Paycheck From Your Primary Job
You know what this is: working for “the man” or “the woman”.
Paycheck From Part-Time Work
Maybe you have a second, part-time job to make ends meet. Or, you work part-time in retirement to stay active. Either way, this is earned income.
Paycheck From A Business You Own AND Work For
Now you are the man! But, you draw a paycheck from your business.
This is how my Dad went about building his finances back in the day. He owned and operated a business with a couple of employees.
My Dad was also an employee and worked at his business 6 days a week, sometimes 7 during his busy season. For that effort, he received a regular paycheck. And that paycheck was earned income.
Money Drawn Out Of A Business That You Own
In this example, you are still the boss girl. And, there is nothing wrong with that!
But, there is no paycheck involved. You just pull money out of your business when you need it.
As an example, that is how my blog works. I make money from marketing activities and advertising.
That money is deposited in a separate bank account. When I want the money, I pull it out of that account and do with it what I choose.
Money Made Side Hustling
It seems like everyone has a side hustle these days. If you make money walking dogs for Rover or giving rides through Uber, you have earned income.
Tax Implications Of Earned Income
Taxes are one of the worst parts of earned income. Why? Earned income is heavily taxed.
I won’t bore you with a tax lesson here. But in a worst-case situation, every extra dollar of earned income can result in the government taking at least 50% of those extra dollars.
Thoughts On Earned Income
Earned income is the type of income everyone in the financial independence community is trying to get away from. Why? You are trading your time for dollars.
You do not have financial freedom. And you are dependent on that next paycheck from the boss.
The boss owns your time. And with every paycheck, federal and state governments take a large share.
Now, there is one big benefit to earned income. You must have earned income to participate in and make deposits to qualified retirement accounts.
Qualified retirement accounts include the 401(k), 403(b), traditional IRA and Roth IRA. Taking advantage of the tax breaks these accounts offer is a great way to build long term wealth.
What Is Passive Income?
The true definition of passive income is very narrow. It is different than what I often see discussed on the internet.
I see articles titled something like “50 passive income ideas…”. Then fill in the blanks. Passive income ideas to build wealth, quit work, work from home or be financially free. You name it, and it’s out there.
And that is okay. Articles like that just take a very liberal approach to passive income.
The liberal and informal definition of passive income is money outside of your full time 9-5 or 24/7 job. Working from home is often included in this loose definition of passive income.
However, if the income results from an active endeavor, it is not passive income. And oftentimes, passive income is confused with portfolio income. So, we will get to the main point of this article in a moment, what is portfolio income?
But before we do that, here is the strict definition of passive income.
Passive income is any rental activity or any business activity in which an individual does not materially participate. And, there are very specific rules that define what material participation is and is not.
Examples Of Passive Income
So then, what qualifies as passive income? Here are the primary examples. It is income from:
- Renting equipment
- Renting real estate
- Owning a business in which you are not involved
That is all that qualifies as passive income.
Thoughts On Passive Income
Passive income is, well, truly passive. It is what we all dream about. That is, making money while we sleep. Taxes on passive income are also lower than taxes on earned income.
But let’s be honest with ourselves. Outside of renting a real estate holding or two, making passive income involves activities that most of us cannot or do not participate in.
What I mean is that it takes a rare and special person to own a successful, profitable business in which they are not actively involved. Most entrepreneurs spend large amounts of time managing their business.
Also, if you become actively involved in renting a large number of real estate holdings, it is no longer considered passive income.
What Is Portfolio Income?
This brings us to the major point of this article. What is portfolio income?
Portfolio income is interest, dividends, or capital gains. It is derived from investments or money lent.
Here is another way to think about portfolio income. Portfolio income is generated from “paper assets”. Owners of these types of assets generally have a piece of paper signifying their ownership. Or, at least they used to.
Many forms of paper assets, like stock certificates and loan agreements, have gone away in this age of digitization. But the term “paper asset” remains.
Examples of Portfolio Income Assets
There are many examples of assets that can generate portfolio income. Sometimes they are called income-producing assets or income-generating assets. Here are several examples :
- Savings accounts
- Certificates of deposit
- Saving bonds
- Money market accounts
- Municipal bonds
- Corporate bonds
- Private loans
- Peer-to-peer lending
- Preferred stocks
- Dividend-paying common stocks
- Open-end mutual funds
- Closed-end mutual funds
- Exchange-traded funds
- Real estate investment trusts (REITs)
- Master limited partnerships (MLPs)
Related: Income assets for making money
Taxes On Portfolio Income
Portfolio income from dividends, interest and long term capital gains get preferred tax treatment.
Dividends and long term capital gains are taxed at lower rates. Also, portfolio income is not subject to Social Security and Medicare taxes.
Why Is Portfolio Income Important?
Goal number 1 for this article is accomplished. I have answered the main question: what is portfolio income? But, I also promised to discuss why portfolio income is so important. Here’s why:
Passive income, at least by the strict definition, is hard to come by for the average Joe or Jane like me. On the other hand, anyone with excess cash can use that cash to build a stream of portfolio income. That’s exactly what saving and investing for retirement is all about.
In more liberal terms, portfolio income is for all intents and purposes, passive. Yes. You have to invest in and manage a portfolio of holdings across a variety of asset classes. But, there are ways you can automate that process. In other words, set it up and forget it.
Portfolio income earns your financial independence. Build enough portfolio income to cover your expenses and you will no longer have to “answer to the man” every day.
Portfolio income is more tax efficient. It is not subject to the highest tax rates like earned income. This is important. The burden of taxes can be one of the largest obstacles standing in the way of building one’s wealth.
Conclusions – What Is Portfolio Income And Why Is It Important?
Portfolio income is neither earned income nor passive income. By definition, portfolio income is interest, dividends, or capital gains. It is derived from investing or lending money.
Earned income is important, especially in our younger years, but it has its drawbacks. Also, passive income based on the strictest definition is not available to average folks like you and me
Life can be a lot better in the long run if you use excess earned income to build portfolio income. Why? Portfolio income buys your financial independence. And, it is tax efficient as you go about building wealth.
Now we know what portfolio income is and its importance in wealth building. In an upcoming article, I will discuss how to increase portfolio income.
Further reading to improve your portfolio income and investment returns
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