Blog | Personal Finance

3 Types of Income and Their Impact on Your Wealth

If you want to be rich, you have to know the difference between earned, portfolio, and passive income

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Summary

  • Most people aren’t aware of the different options to make an income

  • The 3 types of income have different relationships with taxes, which requires a financial education to master

  • Understanding the 3 types of income is part of the path to financial freedom


When Robert Kiyosaki was a child, he spent a lot of time playing Monopoly® with his rich dad. They played for hours, exchanging four green houses for one red hotel. Buried in that simple formula was a powerful lesson that Robert would carry throughout his adult life: the value of cash flow.

Monopoly® is a game that teaches you how to create positive cash flow. You purchase a property and collect rent when someone lands on your property. In order to make money, much like in real life, you improve the value of your properties and eventually sell them. When you move on from single-family homes (green houses) and into larger properties like duplexes, 4-plexes, and, eventually, apartment complexes (red hotels), you increase your cash flow.

All three types of income provide cash flow...but aren’t equal

Because of Monopoly®, Robert learned about cash flow at an early age. Unfortunately, most people never learn these very important lessons.

Most people are given advice instructing them to go to school, get a safe secure job, and invest in a diversified portfolio of stocks, bonds and mutual funds.

But it was by creating cash flow that Robert went on to become a multi-millionaire. And one of the key reasons he became wealthy is because he understood the three different types of income and their relationship to cash flow.

First type of income: earned income

If you have a job and receive a paycheck, you make your money through earned income.

To reference the CASHFLOW® Quadrant Employees (E) and Self-employed (S) people, those on the left-side of the quadrant, make money through earned income.

Quadrant

Examples of earned income

When you earn money through a paycheck, you are exchanging time for money. For example, when you work as an employee as a web designer, a grocery store cashier, or a police officer, you are getting paid a predetermined amount of money (X) to do that job for a certain amount of time (Y). Here in the United States, the amount of money is negotiated between the employee and employer and the amount of time required for a full-time employee is forty hours per week.

The advantages of earned income

Earned income is a good choice for those with a low financial IQ. The formula is very simple: “I’ll do X job and you’ll pay me Y money.” In a good economy, if you do the job well, it’s very stable and you can count on a certain amount of money coming into your pocket each month. In many cases, if you do your job verywell, you get a raise and get even more money in your pocket each month.

Almost everyone in the world thinks a high-paying job is the most secure thing you can have. At Rich Dad, we believe differently.

The disadvantages of earned income

For many people who make their money through earned income, it’s often just enough money to cover basic monthly expenses, leaving little to no money left to invest. For most Es and Ss the saying, “living paycheck to paycheck,” explains their status. If they want to make more money, they need to work more hours at their full-time job or through a part-time job or freelancer.

But even for those who are high paid employees, earned income is very risky. If the economy crashes or the company is mismanaged, your job can be gone in an instant. Unfortunately, millions of people discovered this during the COVID crisis. And many of those jobs simply aren’t coming back.

And perhaps worst of all, earned income is taxed the highest, something we’ll touch on in more detail later in this post.

Second type of income: portfolio income

Where earned income is acquired by exchanging time for money, portfolio income is made through capital gains.

Examples of portfolio income

As an example, when someone buys stock in a corporation at a given price, they plan on selling that same stock at a higher price in the future. So, if they buy a stock at $10 today, and the price goes up to $40 when they sell that stock, they make $30 in capital gains. That capital gains is their profit.

Another example of portfolio income is house flipping. You purchase a run-down home in a nice neighborhood, invest a bunch of money up front to improve it, and then hope you can sell it at a high enough price in order to make a nice profit.

This is how stock traders traditionally make their money. They invest money in stocks they feel are undervalued now with the expectation that when the prices rise they can sell those same stocks for a capital gain.

The advantages of portfolio income

Portfolio income can make you a lot of money in a short amount of time. When the economy is on fire, it can seem like a no-brainer to buy low and sell high. Or if you have insider information, like day traders on Reddit who pushed up the price of GameStop a while back, you can get on the inside track of a rocket ship.

The disadvantages of portfolio income

It’s hard enough for sophisticated investors to make money consistently with portfolio income because it is speculation. As such it can be very risky, especially for those with a low financial IQ and who are following the herd. If you get in late in the game, you can get massacred by those who ran up the price... like many folks did with GameStop.

Portfolio income is also at the mercy of the economy. Many people who were flipping houses in 2008 came to a rude awakening when the entire housing market collapsed nearly overnight. And because a house is a slow liquidity asset...most couldn’t sell in time to recover their losses.

And just as with earned income, you pay very high taxes with portfolio income even when you do realize a profit.

Third type of income: passive income

Rich dad used the formula of “four green houses, one red hotel,” in the game of Monopoly® to describe how you can make passive income, the third and final type of income.

Again referencing the CASHFLOW Quadrant, those on the right-side, Business owners (B) and Investors (I), make money by acquiring assets that provide consistent cash flow.

In Rich Dad Poor Dad,Robert Kiyosaki explains in greater detail what defines an asset. To summarize, an asset puts money in your pocket regardless of whether you work or not.

Examples of passive income

Sophisticated investors invest primarily for passive income. Examples of passive income are rental properties that pay you cash flow in the form of rents (just like Monopoly® !), owning a business that is profitable, or creating a product like a book or a game that pays you money each month in the form of royalties or subscriptions.

Advantages of passive income

Perhaps the best advantage of passive income is that once you have an asset, it provides cash flow whether you’re working or not. Money keeps coming into your pocket and you’re free to do other things...like find more cash-flowing assets.

Even better, the profits from cash-flowing assets can be used to acquire even more cash-flowing assets. And unlike portfolio income, you still own the original asset even as you use the profit from cash flow to buy more cash-flowing assets. It is a compounding effect.

And amazingly, passive income is the lowest taxed income. It’s almost like the government wants you to invest this way.

Disadvantages of passive income

It takes a high financial IQ and patience to invest successfully for passive income...two things most people in the world simply don’t have.

Most people have a low financial IQ. It’s not their fault, necessarily, but the same people who were told to go to school, get a safe, secure job and invest for the long-term in the stock market were also told that their house is an asset. The belief was that your house always goes up in value.

It was only a short time ago (back in 2008) when everyone realized that belief isn’t true. Some people saw the value of their home cut in half virtually overnight. What these homeowners realized was that their home wasn’t an asset but rather a liability.

Where an asset puts money in your pocket, a liability takes money out.

Again, let’s consider your home. Even if you own your house, you still have upkeep, property taxes and utilities to pay for. If your house was an asset, it would make money for you, not take money from you.

Now that you have a basic understanding of the three types of income, it’s time to gain a great understanding of how each affects your greatest expense: taxes.

How taxes affect the three types of income

Ordinary earned income is how most people make a living. It’s also why most people are considered poor or middle-class. But the reason most people are designated poor or middle-class doesn’t have anything to do with how much money they make, but rather how much they keep.

The biggest expense for an E or S on the left-side of the CASHFLOW® Quadrant isn’t their mortgage, car payment or credit card bill. For people who make a living with ordinary earned income their greatest expense is their taxes.

People who earn income through a job (either as an employee or as a sole-proprietor/small business owner) lose roughly 50% of their money through taxes. Earned income is the most highly taxed of all three types of income.

Making money through portfolio income won’t save you much with your taxes, either. No matter how much you make selling stock, or even real estate, you’ll be taxed at approximately 20%.

So, using the previous example about buying and selling stocks (in the portfolio section), if you buy 1,000 shares of stock at $10 and sell the shares for $40, you’ll make $30,000 in profit.

Buy 10,000 shares @ $10 = $10,000

Sell 10,000 shares @ $40 = $40,000

Profit = $30,000

However, once you take 20% off the top for taxes, you would be left with $24,000.

Keep more of what you make

Though you would still make a lot of money, imagine paying nothing in taxes—legally.

When you invest in your financial education and start earning passive income, you’ll not only know how to make money without a job but you’ll pay less in taxes.

Passive income is taxed less than both ordinary earned income and portfolio income because of reasons found in the tax code. Without getting into the details, however, it’s worth noting that the government provides benefits for those who create jobs, Bs and Is. The more jobs there are, the more workers are required to fill those jobs. The more people that are working, the more taxes that can be collected.

Conclusion

You should have a solid understanding of the three types of income—earned, portfolio and passive—and a basic understanding of how taxes affect each income stream.

The purpose of this post was to educate you on the different income options available to you; not to tell you which of the three different types of income you should spend your time acquiring, that’s a personal decision.

One thing you can do today is play CASHFLOW® Classic for free. Stay alert to how you play the game. Are you happy collecting small deals (green houses) or are you playing to win (playing for big deals)? How you answer that question might hold the key to which type of income you should play for.

Original publish date: March 19, 2019

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