The 3 Types of Income
When it comes to your income and how you earn, there are often 3 main types of income. There is active income, such as wages, salary or commission. There is passive income such as rental, interest or royalty income. Then lastly, there is portfolio income such as dividends and capital gains.
For most tax filers active income is often most commonly reported. When you have a job in which they perform tasks for a fixed amount of money, they receive an active income. Active income earners can be full-time, part-time, contractual or freelance professionals and they often receive their income on a weekly, fortnightly or monthly basis, depending on the agreement they have with their employer. You typically acquire active income as one of the following three forms of payment, wages, salary or commission.
Wages is a form of active income that refers to a set hourly rate a professional receives for completing an established number of tasks. If you're a construction professional, the money you earn hourly is an active income because you actively provide your time, energy and expertise to complete a series of tasks for each shift you work. For example, if you work 40 hours over a week at an agreed rate of $20 per hour, you receive a gross wage of $800 for that week.
When you earn a salary it is the amount of money an individual receives for one year of work. While this is like wages in that it's money you earn from providing your professional services, a salary is usually an agreed amount of money that's written into a contract before you commence a job. An employer may pay a salary weekly, fortnightly or monthly. For example, if a professional earns $100,000 per year and they receive monthly payments, they accrue an active income of $8,333.33 per month.
Lastly there are commissions, which is a form of active income where a professional receives a fixed percentage of the amount they generate in sales. For example, a vehicle sales consultant might receive a commission of 5% on each vehicle they sell. If the consultant sells a vehicle valued at $10,000, they receive a $500 commission. An individual might receive a commission in addition to their regular salary, or they may work only on commission.
Now that we have covered the common active income sources let's move onto some of the most popular passive income sources. Passive income is money earned from a particular enterprise in which an individual isn't actively involved. For example, a silent investor might invest capital in a business without participating in its development. If they invest $100,000 in a company with a value of one million dollars, they have 10% ownership and would receive a passive income of 10% of the business profits. Rental investment is another example of passive income. This usually involves the owner of a house or apartment renting their property to a tenant for a fixed weekly or monthly payment.
In addition to a financial investment, there are many passive income streams that require a considerable initial investment of time and energy before they can generate earnings. For example, building a blog may require an individual to produce a lot of content before the site can attract an audience. Only once the website gains large numbers of visitors can it generate a passive income by displaying advertisements.
Another common form of passive income is interest income. As of 2023 the banking industry finally got around to offering fair interest rate yields on most savings and checking accounts. Some as high as 5%, if you left $10,000 in one of these accounts and earned $500 a year in interest on those deposits. This would be an example of passive income earned.
Another form of passive income that is a bit more rare is royalty income. Royalty payments are a form of passive income where someone pays the owner for the use of their property. For example, Amazon pays us a royalty for selling our book on their website.
The last of the three most common types of income is portfolio income. This income is earned from capital gains or dividend income. Capital gains that are earned in a taxable account are taxed depending on how long the investment was held for. If the investment was held for under a year, it would fall under short term capital gains tax, which would be the same tax rates as your ordinary income. If you hold for a year or longer the tax rates are much lower. Dividends are taxed at much lower rates than capital gains and depending on your filing status and income level sometimes can even be as low as 0%. Now if you have a retirement account the capital gains or dividends are not taxed at all while they are held inside those accounts. A topic we will dive into later.
You may have income from all three types, or you may have a mix of two. If you have any more questions about the types of income email Tax@BigPictureSwingTrading.com
Bennett Zamani
Partners at Tax Experts LLC
Call/Text (201) 681-5633
