Three Types of Income, and Which is the Best

We all like making money. But as it turns out, some ways of making money are smarter (more efficient) than others. Of all the possible ways you can make money, there are three types of income: active income, portfolio income, and passive income. Knowing the difference between the three can help you create financial goals that better align with your values.

Active Income

Active income is the most common of the three types. Income is considered “active” when you have to do some type of task in order to be paid. An easy example is your job. You go to work, you do your daily tasks, and then you start receiving paychecks for your work. Pretty simple.

Active income doesn’t only have to be your job, however. Perhaps you have a side-hustle that brings in some extra cash. Maybe you sell some things on Facebook Marketplace or Craigslist. All of these types of activities count as active income. The reason is that you have to put in work in order to receive the money. If you babysit or tutor on the side, you still need to show up (be active) in order to get paid.

Portfolio Income

Portfolio income is money you receive from dividends and capital gains in stocks and ETFs. This is great for the hands-off investor, since you can invest the money and see the returns over the long run. Don’t let this fool you. Investing is not the same as receiving portfolio income. Let’s look at an example.

If you invest $10k into an index fund, and two years later the fund is valued at $12k, how much money have you made? If you said $2k, I urge you to reconsider. While your portfolio earned $2k, you don’t physically earn that money until you withdraw from the index funds. So in essence, you have received nothing. You receive portfolio income when you sell your stock for capital gains.

One of the best ways to receive portfolio income without extensive buying or selling is through dividends. Certain companies offer dividends for buying their stock. The dividends are typically a small percentage of the company’s profits, and you receive money proportional to the number of shares you hold.

You can either reinvest the money as part of a dividend reinvestment plan (DRIP), or cash out the dividends as income. If you are interested in learning more, I recommend you check out this site.

Passive Income

Finally we come to what I consider the holy grail of income: passive income. This is income that you receive for doing next to no work. Examples include collecting rents from tenants, affiliate programs, and earning royalties.

Passive income is my favorite type of income of the three. This is because you don’t have to keep working once you start making money. Unlike a job where they don’t pay you if you don’t show up (assuming you don’t have paid time off), you can sit back and relax and still collect from passive income sources.

Take an affiliate program as an example. If you become an affiliate, it’s work at first to start having people use your promo codes and links. The money you receive isn’t a ‘once and done’ however. If you get a friend to buy a service using your code, as long as they use that service, you make a portion of the sale.

The Active-Passive Income Spectrum

I personally believe a lot of active and passive income actually falls on a spectrum. Really you can argue just how active or passive your income source is. I can receive rent from a tenant monthly, but if I have to do monthly maintenance on the apartment then is it really passive? You can argue “yes”, with the logic that the tenant will continue to pay and you get a large sum of money for putting in only a few hours of work per month. You can also argue “no” and say that it could be truly passive if I hire a property manager to take care of the monthly maintenance.

Whichever way you look at it, the fact of the matter is how that income compares to my other sources of income. Is the income that I receive from my tenant more passive than the income I receive from my job? Absolutely. I’m not helping my tenant for 40+ hours per week.

Which Should You Strive For?

I will never tell you what you should and shouldn’t do. If you’ve read some of my other posts, you know that I believe it’s up to you to decide what is best for you. My only goal here is to make information and ideas readily available to you so you can form your own opinions.

That being said, I think passive income is the best.

I personally try to make my active income as passive as possible. Through spending less money, I invest my extra money in assets that will pay me money, like my rental property. Eventually, I want my passive income to be enough where I can choose to retire early if I want to.

Don’t be fooled, passive income isn’t something you can start making overnight. Well, you can, but it won’t replace your job any time soon. Rather, passive income builds slowly. I’ve found that creating a long term financial plan for yourself is a great path forward.

Final Thoughts

While all three types of income are valid ways of making money, it’s important to know which one is best for you. Active income is the easiest to do, but too much ‘activity’ can leave you burned out. Then you won’t have any time to do things you enjoy! I recommend taking a look at your values, figuring out your ideal lifestyle, and spending accordingly. You can then use all of the money you save to convert active income into portfolio or passive income as you please.

Not sure where to start? Check out this post where I break everything down and help give you actionable steps to get off on the right foot.

Happy spending!

-The Spendgineer