What are the Four Categories of Income?

You’ve probably heard the phrase “make your money work for you” more than once. Sounds great, right? But how does one actually accomplish that? The key to unlocking this lies in understanding income in its varied forms. More precisely, there are four main categories of income that you should get familiar with. 

If you’re ready to gain a deeper insight into how you can diversify your income sources, then you’ve come to the right place. Let’s get down to the nuts and bolts and unpack these four categories.

1. Earned Income

The most familiar category to most of us is earned income, which is essentially the money you make from working. This is your nine-to-five job, your freelance gigs, your side hustles – basically, anything where you’re trading your time and energy for money. Whether you’re getting paid an hourly wage, a salary, or a project fee, it’s all earned income.

Let’s look at a few specific examples to get a clearer picture:

The Nine-to-Five Job

Most commonly, earned income comes from a traditional job where you receive a regular paycheck, typically bi-weekly or monthly. This might be anything from a blue-collar job, like a mechanic or a plumber, to a white-collar job, like a lawyer or a project manager. 

Regardless of the nature of the work, the common denominator is that you’re trading your time, skill, and energy for money.

Freelance Gigs

With the rise of the gig economy, freelance work has become a popular source of earned income. 

From graphic designers and writers to software developers and consultants, individuals can offer their skills on a project-by-project basis. Here, payment often comes in the form of project fees.

Side Hustles

These are income-generating activities you engage in outside of your regular job. Maybe you drive for a rideshare company on the weekends, sell handmade jewelry on Etsy, tutor high school students in math, or run a blog that earns advertising revenue. 

Time Is Money

As straightforward as earned income may seem, it does come with its limitations. The most significant downside is that it’s tied directly to your time, which is a finite resource. There’s a limit to the number of hours in a day that you can work, which places a cap on the amount of money you can make from earned income. Not to mention, burnout is a real risk if you’re constantly pushing that limit.

On top of that, earned income is often subject to higher tax rates compared to other types of income. This is important to consider when strategizing your overall financial plan, as keeping more of the money you make is just as important as making more money.

So, while earned income is the backbone of most people’s financial situation, understanding its limitations is the first step towards diversifying your income and building wealth.

2. Portfolio Income

Next up is portfolio income. This category encompasses all investments that appreciate in value and can be sold for a profit. These can include anything from commodities like gold or oil, real estate investment trusts (REITs), or even artwork and collectibles.

For example, let’s say you bought 100 shares of a company’s stock at $10 each. You spent $1,000. Then the stock price rises to $15 per share, and you decide to sell. You make $1,500, earning a profit of $500. That $500 is your portfolio income.

Let’s take a look at some specific examples:

  • Stocks – If you bought 100 shares of a company’s stock at $10 each, spending $1,000 in total, and the stock price rises to $15 per share, you could decide to sell. Doing so, you’d make $1,500, earning a profit of $500. That $500 is your portfolio income. 
  • Bonds – Let’s say you purchase a bond for $900 that has a face value of $1,000 (the amount you get when the bond matures) and earns annual interest of $30 (3% of $1,000). Here, your portfolio income is twofold – the $100 gain if you hold the bond till maturity and the recurring $30 annual interest.
  • Mutual Funds – Suppose you’ve invested in a mutual fund by purchasing 200 units at $20 each, costing you $4,000. Over time, the Net Asset Value (NAV) of the fund increases to $25 per unit. If you decide to sell your holdings, your total comes to $5,000, leaving you with a profit of $1,000.
  • Real Estate Investment Trusts (REITs) – Imagine you invest $5,000 in a REIT. Over a period, the trust appreciates in value due to the rising value of the properties under its management, and your investment is now worth $6,000. When you sell your stake in the REIT, the $1,000 profit you make is classified as portfolio income.

While portfolio income can be a great way to earn money without actively working, it does come with risks. The stock market can be unpredictable, and it’s entirely possible to lose money instead of making it. It requires a good understanding of the market, the ability to manage risk, and a strong tolerance for potential losses.

A Layer of Risk

The value of these assets can be volatile, affected by numerous factors, including economic indicators, market sentiment, and geopolitical events, among others. For instance, a company whose stock you own might report poor quarterly earnings, leading to a drop in stock price. Similarly, a rise in interest rates might reduce the value of the bonds you hold.

Thus, earning through portfolio income requires careful planning, diversification to spread the risk, and a keen eye on market movements. And above all, it requires patience. 

Unlike earned income, which is relatively predictable, portfolio income is often about playing the long game, riding out the market’s ups and downs, and holding onto your investments until they’ve appreciated enough to provide a significant return.

While portfolio income can lead to lucrative returns, it’s crucial to only invest money that you can afford to risk and always ensure you’ve done thorough research or consulted with a financial advisor. It’s all about striking a balance between risk and reward!

3. Passive Income

Ever dreamed of earning money while you sleep? That’s what passive income is all about. It’s income you earn from something that requires little to no effort to maintain. This includes income from rental properties, royalties from a book or song, or earnings from a business where you’re not actively involved.

While passive income sounds like a dream, there’s often the misconception that it doesn’t require any work. In reality, the opposite is true. Usually, there is substantial upfront work and time investment needed to set up a passive income stream. 

E-commerce and Digital Products

In today’s digital age, passive income has taken on new forms. Once your product or course is created and available online, customers can buy it any time, day or night, without any additional effort on your part. 

Here are some examples of increasingly popular digital products or services that can generate passive income:

  • Ebooks – Once you’ve written and published an ebook, whether it’s a guide on home gardening or a fantasy novel, it can be purchased and downloaded from anywhere in the world, any time of day or night.
  • Online Courses – If you have expertise in a particular field, you can package that knowledge into an online course. Platforms like Udemy or Coursera allow you to reach a global audience.
  • Mobile Applications – If you’re tech-savvy, designing a popular app can be a powerful passive income stream. This could range from a helpful productivity tool to an engaging game.
  • Stock Photography – If photography is your passion, your pictures could become a source of income. Websites like Shutterstock or Adobe Stock allow you to sell your photos worldwide.
  • Digital Art and Printables – Artists can sell their work digitally as prints, t-shirts, or other merchandise. Platforms like Etsy or Redbubble make this process relatively easy.
  • Membership Sites or Patreon – If you create regular content, like podcasts or comics, you might consider setting up a membership site or Patreon. Subscribers can provide a steady income stream in return for access to exclusive content.
  • Affiliate Marketing – By promoting other companies products or services on your blog or social media, you can earn a commission on any sales made through your referral link.

4. Business Income

The last piece of our income puzzle is business income. This refers to the money you earn from a business or trade in which you’re actively involved. Unlike passive income, where your role might be more hands-off, business income requires your constant attention to maintain and grow.

One of the most enticing aspects of owning a business is the potential to scale. While a traditional job might offer annual raises or promotions, the growth in income is usually incremental and bound by certain limitations. But when you own a business, the ceiling is potentially much higher.

In business terms, scaling refers to your ability to increase your business income proportionally faster than your costs. For example, if you own a software company, after the initial development, you can sell thousands of copies of your software without significantly increasing your costs. The cost of creating one more copy of your software (the marginal cost) is very low compared to the price you can sell it for. This is the beauty of scaling.

The Path to Wealth 

Each of these categories of income has its own benefits and challenges, and it’s important to consider your personal circumstances, risk tolerance, and long-term goals when deciding where to focus your income-earning efforts.

Remember, the goal isn’t just to make money but to build wealth. Knowing these four categories of income helps you understand the broader picture of wealth creation. So now, it’s time to leverage this knowledge, explore these avenues, and work your way toward financial freedom!