You can make money in all sorts of ways. Perhaps you collect a paycheck every other week, or do freelance work that flows into your checking account. Or maybe you have a rental property that keeps rent rolling in, stocks that are throwing off dividends, or a savings account that is earning a bit of interest.
All of these are different sources of income. Here, we’ll take a look at seven types of income and how they might fit into your financial life. It will also give you a better picture of the ways that money can find its way to you, which is good money-smart knowledge to have.
What Is Income?
Let’s get the basics down. Simply put, income is money that a person or business earns in return for labor, providing a product or service, or returns on investments. Individuals also often receive income from a pension, a government benefit, or a gift. Most income is taxable, but some is tax-exempt from federal or state taxes.
Another way to think about income types is whether it is active (or earned) or passive (or unearned). Active or earned income is just what it sounds like: money that you work for, whether you are providing goods or a service.
Other kinds of income may be referred to as passive income or unearned income because you are not actively doing anything to get the money. For instance, if you have a certificate of deposit (CD) that earns you interest, that is passive income. Government benefits, capital gains, rental income, royalties, and more are also considered passive income. (We’ll go through these variations in more detail in a minute.)
People who are paid a salary may tend to think that their annual paycheck earnings are their income, but in truth, it’s common for many people to have multiple income streams. Granted, your salary may be by far the largest stream of income, but when considering your overall financial picture, don’t forget to think about the other ways that money comes to you.
Different Types of Income
Now that you know the answer to “What is income?” question, let’s look at the various kinds of Income is usually categorized as seven different types of income (though these may also be called income streams). Let’s go through them one by one.
1. Earned Income
Earned income is the money you earn for work you do, either in a job or self-employed. Earned income includes wages, salaries, tips, and bonuses.
Earnings are taxed at varying rates by the federal and state governments. Taxes may be withheld by your employer. Self-employed workers often pay quarterly and annual taxes directly to the government. Low-income workers may be eligible for the earned income tax credit.
2. Business Income
Next up: What is business income? This is a term often used in tax reporting; you may sometimes also hear it referred to as profit income. It basically means income received for any products or services your business provides. It is usually considered ordinary income for tax purposes.
Expenses and losses associated with the business can be used to offset business income. Business income can be taxed under different rules, depending on what type of business structure is used, such as sole proprietorship, partnership, corporation, etc.
3. Interest Income
When you invest in various types of interest-bearing financial vehicles, the return is considered interest income. Retirees often rely on interest income to fund their retirement. You can earn interest from a variety of sources including:
• Certificates of Deposit (CDs)
• Government bonds
• Treasury bonds and notes
• Treasury bills (T-bills)
• Corporate bonds
• Interest-bearing checking accounts
• Savings accounts
In most cases, interest income is taxed as ordinary income. Some types of interest are fully taxable, while other forms (such as interest from Treasury bonds) are sometimes partially taxable. Worth noting: Money-market funds distributions may seem like interest, but they are usually considered dividends.
4. Dividend Income
Some companies pay stockholders dividends as a way of sharing profits. These are usually regular cash payments that investors can take as income or reinvest in the stock. Dividend income is one of the most common ways investors can make money from stocks.
Dividends from stocks held in a taxable brokerage account are considered taxable income. These funds will be taxed at your regular income-tax rate or as a long-term capital gain. By contrast, dividends that are paid from a stock held inside a tax-advantaged savings account such as an IRA or 401(k) are not taxed.
5. Rental Income
Just as it sounds, rental income is income earned from rental payments on property you own. This could be as straightforward as renting a room in your house or as complicated as owning a multi-unit building with several tenants.
Rental income can provide a steady stream of payments that may enhance your livelihood or even be your main income. When your rental property increases in value, you may also gain from that appreciation and increase in equity. In addition, rental income qualifies for several tax advantages, including taking depreciation and some expense write-offs.
But there are downsides. Owning a rental property isn’t for the faint of heart. Unreliable tenants, decreasing property values, the cost of maintaining and repairing properties, as well as fees for rental property managers can all take a bite out of your rental income stream.
6. Capital Gains
Another important income stream can come from capital gains. You incur a capital gain when you sell an asset for more than what you originally paid for it. For the purposes of capital gains, an asset usually means an investment security such as a stock or bond. But it can also encompass possessions such as real estate, vehicles, or boats. You calculate a capital gain by subtracting the price you paid from the sale price.
There is another key point to know on this topic: Two types of capital gains are possible — short-term and long-term.
• Short-term capital gains are realized on assets you’ve held for one year or less.
• Long-term capital gains are earned on assets held for more than a year.
The tax consequences are different for each type of capital gain. Short-term gains are taxed as ordinary income, while long-term capital gains are taxed at a lower rate depending on income. Most taxpayers pay 15% on long-term capital gains.
Keep in mind, that capital losses can happen too. That’s when a capital asset is sold for less than the purchase price. While it’s never pleasant to experience losses, there can be a small silver lining in this case. Many times capital losses can be taken as a tax deduction against current and/or future capital gains.
7. Royalty Income
Royalty income comes from an agreement allowing someone to use your property. These payments can come from the use of patents, copyrighted work, franchises, and more. Let’s consider an example or two. Inventors who sell their creations to a third party may receive royalties on the revenue their inventions generate. Celebrities often allow their name to be used to promote a product for royalty payments. Oil and gas companies pay landowners royalties to extract natural resources from their property. The market for music royalties has been particularly lucrative in recent years with the proliferation of music streaming services.
Royalty payments are often a percentage of the revenues earned from the other party using the property. Many things impact how much royalty is paid, including exclusivity, the competition, and market demand. How royalty payments are taxed can also vary, depending on the type of agreement.
Now that we’ve reviewed the seven different types of income, you may be wondering, “What about residual income?” That’s a term that doesn’t actually describe money that’s heading your way. Instead, think of that as the amount of your income left over after you’ve paid your financial obligations. It’s similar to discretionary income. Sorry, not another way to enrich your bank account!
Understanding the seven general income streams can help you make the most of income opportunities in your financial planning. Earning income from any of these sources can add stability to your finances and help achieve long-term goals such as saving for retirement. Because some types of income have unique tax treatments, it can be important to check with your tax advisor about any tax consequences income will bring to your financial picture.
Aside from earned income, it’s likely that interest is the kind of income most people receive. And seeking out the best possible interest rate can be a very nice way to enhance your money. That’s why SoFi’s high yield banking is proud to offer a hyper-competitive rate of 1.25% APY when you open an account with direct deposit. What’s more, we don’t eat away at your funds with fees: SoFi doesn’t charge eligible accounts any monthly, minimum balance, or overdraft fees.
Let SoFi show you the smarter way to bank.
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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.