Emlyn Scott is the founder of Rich1Percent, investor and wealth creation author. He is a wealth creation and finance expert with 4 post graduate qualifications (BEc, GDAFI, MBA, CFA) from over 10 years of post graduate study and over 15 years of hands-on finance and investment experience. He has amassed a multi-million dollar investment portfolio and is author of Wealth Buys Freedom, which describes the wealth creation formula. For a more detailed biography of Emlyn Scott click here. He can be contacted at emlynscott@rich1percent.com.
We all think we know what income is. In this article we look at the various forms of income, their characteristics and identify the type of income that the poor, middle class and wealth earn.
We all think we know what income is. For most of us it's simply the salary we earn in exchange for our time. More precisely it's the money, or its equivalent, that's received in exchange for labor or services, from the sale of goods or property, or as profit from financial investments. But there's a lot more to it than that especially from the wealth creation perspective.
Three types of income
The Internal Revenue Service (IRS) in the U.S. classifies all income and loss items into three categories: active, passive and portfolio.
- Active income. This is also referred to as earned income. It's income from salary, wages, fees, commissions, farms, sole proprietorship business, S corporation and partnership income where the taxpayer materially participates in the business operation.
- Passive income. This is income that's received, usually regularly, by an individual who doesn't materially participate. It doesn't require additional effort to receive this category of income. The only effort required is usually upfront to establish the income stream rather than on an ongoing basis. Types of passive income include rental from real estate, royalties from patents and license agreements, and businesses you own.
- Portfolio income. This is also referred to as investment income. It's income from paper investments such as stocks, bonds, mutual funds in the form of interest received or dividends or capital gains (or losses) from their sale. Portfolio income is income that's generated by an activity that's not considered a trade or business.
The significance of separating income into these three categories is twofold:
Firstly, it's crucial from a tax perspective. In economies like the United States and Britain, losses from one category—passive losses from a rental property, for example—can generally only be offset against gains in the same category, i.e., another profitable rental property. In other words, rental losses can't be offset against income in another income category such as your salary (active income) or dividends (portfolio income). Unused losses in a category can be carried forward, usually indefinitely, to be offset against gains in the same category in future years.
The second significant reason for separating income into its various types is from the wealth perspective. Income occurs in return for renting or selling an asset that someone sees as valuable. Each of the three incomes come from selling their respective assets. Active income from active assets, passive income from passive assets and portfolio income from portfolio assets. The extent of the perceived value is reflected in the amount someone is willing to pay in return for a particular asset. One of the most common assets is people. Yes, you and I are assets as well! Our income is a reflection of what someone else perceives us to be worth. You and I are active assets and we rent our time to others and receive active income in the form of a paycheck in return.
The poor and middle class generate almost all their income from active income in the form of paychecks from their jobs. This can be as an employee or as a self-employed individual. They trade their time for a wage and their earnings are limited. Active income earners simply can't create twenty-five hours in a twenty-four-hour day, and since they receive their income in return for their time, the moment they stop working they lose their income.
The wealthy, on the other hand, earn their income primarily from passive and portfolio income. The wealthy realize that passive and portfolio income is infinitely better than income from a paycheck for four major reasons:
- It's theoretically unlimited. This is because ownership of these types of assets is theoretically unlimited. Bill Gates owns billions of dollars worth of Microsoft stock that pays him millions in portfolio income. Donald Trump owns billions of dollars worth of property, which pays him millions in passive income. If they earned paychecks by selling their time in nine-to-five jobs, there's no way they would be able to generate the incredible incomes they do.
- It's independent of the owner's time. In other words, the income keeps coming in whether they get out of bed in the morning or not.
- It's both realized and unrealized. Realized income is taxable, whereas unrealized income is not taxed until it's realized. Active income is realized income, whereas passive and portfolio income have a realized and unrealized component. This allows you to take full advantage of compounding as you are deferring your taxes. Bill Gates, who set up Microsoft in his garage, has never had to pay a cent on the value of his holdings in Microsoft. He only pays taxes if he sells stock. He's made billions, tax-free!
- It has a number of tax advantages. Passive and portfolio income generally isn't taxed before you receive it, unlike your paycheck. It offers, in some situations, that ability to defer payment such as the U.S., IRC Section 1031 offers and allows far more tax deductions that active income.
In summary, those that want to take the wealth journey understand the three types of incomes that are available and that they're earned from their respective active, passive and portfolio assets. The wealthy concentrate on building their passive and portfolio incomes by owning passive and portfolio assets.