What is Portfolio Income & 5 Reasons it is Important

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Portfolio Investment Income: Your Key To Building Wealth

Today, let’s fully understand the answer to this question: what is portfolio income?

Because your income is the engine that drives the amount of money you will have in life. So, I want to explain the 3 different types of income. Also, why the third type, portfolio income, is so important to accumulating 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.

Let’s start with the key takeaways from the article. First, portfolio income defined. Second, the importance of portfolio income for you and me.

Disclosure: At no cost to you, I may get commissions for purchases made through links in this post.

Portfolio Income Definition

Also known as investment income, portfolio income is interest, dividends, or capital gains. It is derived from investments or money lent.

Next, let’s discuss the importance of portfolio income. By knowing these points, you may be encouraged to pursue an investing for income strategy.

5 Reasons Portfolio Income Is Important

Building a portfolio income stream is accessible to the average investor
Earning portfolio income takes little of your time and effort
Portfolio income is more tax-efficient than other forms of income
Portfolio income is a stepping stone to financial freedom
Building sustainable wealth is partly dependent on portfolio income

With those key points taken care of, let’s compare and contrast portfolio income to other forms of income. Then circle back to portfolio income and fill in some of the details to better understand it and maximize it. To help you build your portfolio investment income stream.

Portfolio Income Versus Passive Income And Earned 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 improve your chances of achieving your financial goals.

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?

portfolio income versus passive income versus 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.

Resource: An easy side-hustle for extra cash

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.

Final 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, let’s set the record straight. And strictly define 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.

Final 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 real estate assets, 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 profitable investment asset like a 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.

This brings us to the major points of this article…

What Is Portfolio Income?

Portfolio income is interest, dividends, or capital gains. It is derived from investments or money lent.

Related: 60+ assets for capital gains

Here is another way to think about portfolio income. It is income 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.

Paper assets can be contrasted with physical assets. These assets have a material existence that can be seen and touched.

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)
Options

Related: Income assets for making money

Taxes On Portfolio Income

Here is some good news. Income from dividends, interest, and long-term capital gains receive preferential tax treatment.

Dividends and long-term capital gains may be taxed at lower rates. Also, portfolio income is not subject to Social Security and Medicare taxes.

You will still have to pay taxes. So be sure to consider income taxes in your investment income calculations.

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 another point about income investing.

Specifically, why fixed income from your investments 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. And maybe you too? But creating multiple streams of passive income is one of the many positives about investment income.

On the other hand, anyone with excess cash can use that cash to build a growing income stream. That’s exactly what saving and investing for retirement is all about.

Resource: Manage your total financial picture for free with Personal Capital

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 steady income from investments 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.

So, we know portfolio income is very important. Then how do you and I go about increasing it?

Because more income is better than less. Let’s touch on this topic. Before we wrap up.

8 Ways To Increase Portfolio Income

Invest new capital into your portfolio. This is the starting point. Also, the most fundamental way to increase portfolio income.

But, once you build an income portfolio. It opens up other options to increase the income it pays.

Target new money at investments with higher interest rates or yields. But use caution. Higher paying income investments usually mean higher investment risk.

Change your mix of investment portfolio holdings. Sell lower yielding portfolio assets. And put the proceeds in higher yield holdings.

Reinvest dividends and interest back into your income portfolio. Reinvesting portfolio income is critical to compounding your wealth.

Whether you automate reinvestment. Or, do it manually, it doesn’t matter. There are pros and cons to each method. Just be sure to do it!

Invest in dividend growth stocks. Stocks that increase dividends each year are a great option. Just buy and hold. With each dividend increase, your income increases. This is one of the most passive ways to increase your portfolio income.

Resource: Invest in stocks fast & free using the Webull app

Strategically sell holdings in the portfolio. Sometimes this is referred to as creating “homemade dividends” from capital gains on individual investments. Versus income investors, growth investors must use this approach to create income from their portfolios.

Reduce taxes on portfolio income. Even though this type of income has tax advantages. There are several ways to be even more tax-efficient…

Invest in qualified retirement accounts. For example, an IRA. Also, keep your portfolio turnover low. And, invest in municipal bonds. These are some of the best options to consider.

Resource: Open an IRA with M1 Finance

Finally, keep investment fees low. Because investment management fees are subtracted from your income stream. Just like taxes, they take money out of your pocket.

Time to wrap this up…

Conclusions – What Is Portfolio Income And Why Is It Important?

Portfolio income is neither earned income nor passive income. By definition, this form of income is represented by interest, dividends, or capital gains. It is derived by 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? Because this type of income buys your financial independence. And, it is tax efficient as you go about building your wealth.

My Favorite Personal Finance & Investing Resources

Throughout this article, I mentioned several of my favorite investing and money management resources. I have summarized them here for your convenience.

Personal Capital for managing your finances

Webull for fast, free online stock trades

M1 Finance For IRA accounts and personal financial services

Survey Junkie: earn cash for taking consumer surveys

Author Bio, Disclosure, & Disclaimer: Please join me (Tom) as I try to achieve my goals, find my next place to live, and make the most of my money. However, I am not a licensed investment adviser, financial counselor, real estate agent, or tax professional. Instead, I’m a 50-something-year-old, early retired CPA, finance professional, and business school teacher with 40+ years of DIY dividend investing experience. I’m here only to share my thoughts about essential topics for success. As a result, nothing published on this site should be considered individual investment, financial, tax, or real estate advice. This site’s only purpose is general information & entertainment. Thus, neither I nor Dividends Diversify can be held liable for losses suffered by any party because of the information published on this website. Finally, all written content is the property of Dividends Diversify LLC. Unauthorized publication elsewhere is strictly prohibited.

Portfolio Income Meaning, Definition & Explanation