Understanding the Three Different Types of Income

Part of learning to become financially free is to begin to understand that there are three different types of income. They are: capital gains, passive income, and earned income. They are the three types of ways to make money, and are very easy to understand.

Capital Gains - When you buy a stock, and sell it for a higher price, you have made a capital gain. If you buy a house and then later sell it for a profit, you have made a capital gain. If you buy an antique at a low price and then sell it for a nice profit, you have made a capital gain. Capital gains are not passive income. They are a one-time payment that you receive from an investment because your investment has increased in value. Investing for Capital Gains is great because you can keep your money moving, instead of just letting it sit in the bank. The government loves to tax capital gains, especially if you bought and sold your investment in less than one year. Lets say you buy a stock, and the stock doubles in price during the week so you decide to sell it. You've made a nice capital gain, but the government could take as much as 35% on that capital gain, depending where you are in the income-tax bracket. If you hold onto your investment for a year or more, the government rewards you with a more favorable capital gains tax rate.

Passive Income - Passive income is payments that you receive from the assets you have created. These payments usually come monthly, and require little or no work for you to receive them. Some types of assets that produce passive income are rental properties, dividend stocks, and businesses. Assets that produce passive income continue to do so until the asset is liquidated (sold). Passive income is what makes a person rich. If a person has more than enough passive income to cover his or her expenses, that person is rich.

Earned Income - Earned income is the primary source of income for most American's today. Any type of job that pays an hourly wage, pays earned income. People who rely only on earned income, pay the most taxes. Federal, State, Unemployment, Social Security, and Medicare taxes are all deducted from a persons paycheck. With passive income and capital gains, the types of taxes you pay (if you have to pay any at all) depend on your investment. Earned income is not necessarily a bad thing. Having a job or career is a great way to earn the capital required in order to create assets.

Almost everyone who starts his or her own journey to financial freedom begins with earned income. Relying solely on earned income should be temporary. In America today, many people rely on earned income alone, and saving most their earned income for many years until they retire. The path to financial freedom requires making the transition from relying on earned income, to passive income

Michael Press is an investor and teenage entrepreneur. He currently owns and operates PassiveIncomeInfo.com, a free website with articles about how to build wealth.