As you may have derived from the title of this article, not all income is created equal. In fact, the Internal Revenue Service categorizes income into three broad types, Earned Income, Passive Income, and Portfolio Income. While passive and portfolio are income is generated via investments, earned income is either employment or self-‐‑employment (income. The principals and methods governing the three are substantially different, and most importantly, the rules relative to taxation are different as well. In my opinion, knowing these distinctions holds the key to financial freedom.
In this article, you’ll see the analysis of Earned Income vs Passive Income vs Portfolio Income.
Most people live in the world of Earned Income, which is to say that the vast majority of us generate income in exchange for our labour and/or services. Simply put, earned income is what you get paid by working at a job as either an employee or an independent contractor. If you are an employee, your earned income comes to you in the form of paycheck, usually at regular intervals like weekly or bi-‐‑weekly and in set amount. In this arrangement, the majority of taxes have already been taken out of your check by the time you receive it.
This works a little differently for those who are self‑employed, like contractors or freelance musicians.
First of all, while employees count on regular paychecks from their employers, self-employed earners often experience significant variances in their paydays depending on the terms negotiated with their customers and their ability to find work in the first place. Also, a contractor may do a room addition and two roof replacements during one month, earning him £25,000, but have no significant business during the next three months. This reality requires that self-employed people become good money managers.
Furthermore, in the world of the self-employed no one withholds taxes from our paychecks on our behalf. It is our responsibility to figure out who and what we money for, and to file the proper returns with the HMRC
However, regardless of whether you are self-employed or an employee at a company, your income most likely falls under the category of earned income, because you literally had to earn it with your labour!
Passive Income – The Magic Wallet
In direct opposition to the idea that you have to be employed in order to earn income, is the notion of passive income. The concept of earning income without work is quite difficult for most of us to comprehend since we’ve all been conditioned by our parents and teachers that we must “work hard” in order to achieve. What they didn’t tell us is that by working smart, we can greatly diminish the amount of effort required to achieve our goals.
HM Revenue and Customs defines passive income as income from “ʺtrade or business activities in which you do not materially participate…” If it seems to you that this definition implies a possibility of earning income without working for it – without your material participation, you are right! This is, in fact, the implication.
I like to illustrate passive income in the following way. Imagine you have a wallet with £3,000 in it. On the first day of the month you open your wallet and take out £3,000 to spend on whatever you wish, leaving the wallet completely empty. But by the first of the next month another £3,000 magically appears inside the wallet, ready to be spent all over again. I call this metaphor The Magic Wallet, and it is my financial goal in life. Now, if you want to have a little fun, try imagining £20,000 instead of £3,000. Welcome to the life of the financially free!
Don’t misunderstand me. I am not at all suggesting that you shouldn’t work hard. I simply want to draw a distinction between working hard at trading pounds for hours, verses working hard at educating yourself how to work smart!
Some examples of passive income are rents from real estate, business income (which does not require the owner’s direct involvement), royalties from a patent or a book, pension income, etc.
Portfolio income is income resulting from paper investments like capital gains, dividend, and interest income that you might receive from ownership of stocks and bonds..
Tax Comparison on Earned, Passive, and Portfolio Income
As I mentioned previously, HMRC tax code treats the three types of income very differently.
Earned Income and Taxes
Earned income is the highest taxed income of the three. With the current individual tax rates ranging from 10% to 35%, and the top rate likely to soon go up to 39%, the tax bill can really add up quickly. In addition, earned income is subject to other taxes, such as National Insurance and state pension which are roughly 14%. What’s more, while an employee benefits from their employer paying half of these taxes, the self-‐‑employed earner pays the entire 14%.
Portfolio Income and Taxes
Portfolio income, at least as it relates to dividends, interest, and capital gains resulting from the sale of investments held for longer than twelve months, is currently taxed at no more than 20%.
Passive Income is Taxed Least
Passive income from investment activities such as rental of real property is the least taxed of the three. It offers even more advantages, and it is not uncommon for an investor to pay only a 10% to 15% effective tax rate..
Taxes and Building Wealth
This is so important because the burden of taxes can be one of the largest obstacles standing in the way of wealth accumulation. But it doesn’t have to be – it is a matter of perspective. I have come to realize that the tax code is how our government communicates with the citizens. We live in a free society in which our politicians can not arbitrarily tell us what to do and how to make money. However, it is completely understandable that the government would want to try enticing us to do what they want us to do, which is achieved through lowering tax burden on income resulting from those activities in which they want us to participate. This is what makes it feasible to lower your tax liabilities legally, by simply following the instructions inside the tax code itself.
As such, the reality that investment income is taxed at a much lower level than earned income tells me that our politicians would like to incentivize people to become investors. Through the tax code they effectively communicate the message – if you earn money as an investor, you will be able to keep more of it. I say - O.K.
Tax and Earnings Type Case Study
Consider this in terms of numbers. Suppose this year you earn £150,000. If you’ve earned it as an employee, then you will lose about 50% of it to taxes, leaving you with £75,000 of net income. If, however, you earn this money by way of investing, then you will only lose 20%, or less, of it to taxes. This would leave you with £120,000 of net income, which is £55,000 more. This is the advantage of earning income through investments. (Note – these numbers are for example purposes only. Consult your Tax professional.)
Here is another way of thinking about this. Suppose you’ve decided that you need to net £75,000 per year in order to maintain your lifestyle. If you decide to achieve this goal by way of earned income, you will need to gross £150,000 so that after you pay taxes there is £75,000 left for you to live on. However, you will only need to generate £93,750 of investment income in order to net the same amount.
There are two questions you must ask yourself around this reality. First, if you are going to be able to earn £150,000 this year, would you rather lose £75,000 of it to taxes or £18,000? Also, if £75,000 is what you need to live on, do you think that you would have an easier time getting there by way of £150,000 of earned income or £93,750 of investment income? I’ll give you a clue: Both require knowledge, but it’s very different types of knowledge. In my opinion, it is considerably easier to acquire the type of knowledge which would allow you to generate investment income rather than earned income. Information is readily available and no college degree is necessary!
Choose Your Income Type Wisely: Learn How to Invest
Realizing that taxes are at the very top of the list of things that could cost you a lot of money, and therefore get in the way of wealth creation, I think it pays to try to pick a mode of income-‐‑generation with the least exposure to taxation. When I mentioned at the outset that understanding the above distinctions holds the
key to financial freedom, I did so because it is extraordinarily unlikely to achieve financial freedom through earned income since it is taxed so heavily.
Sure, there are professions which offer such high pay that makes it possible to lose 50% of it to taxes and still be left with very comfortable net income. But very few of us are in one of those professions; certainly not me. The alternative is to learn how to invest.
Posted by Eso Akpovwa
“Invest property wise”
I needed a new audiobook. In the year and a half since my first son had been born, I’d read three or four parenting books. These covered topics like brain development and the traits that will make your child successful. It left me feeling uneasy. I was a smart kid growing up. I did well in school and managed to get an Engineering degree. But I didn’t actually consider myself all that successful, at least not financially. I mean, I made pretty good money compared to the average person, but my wife and I had money concerns like everybody else.
I was out for a long walk to get some exercise, pushing a stroller that now had one tiny little passenger.They were depending upon me. I would be lying if I told you that didn’t weigh heavily on my mind. I decided to listen to another parenting book. This time, I found one called Rich Dad Poor Dad: What The Rich Teach Their Kids About Money That the Poor and Middle Class Do Not! by Robert T. Kiyosaki. “Well,” I thought, “I’d like to teach my kids about money.” The problem was, I didn’t know anything about it. “Maybe this will help.”
Little did I know that the lessons I would find in that book would change my life.
The thing is, it hadn’t really occurred to me that my life needed to change. I had a university education, a successful career, and a solid income comfortably above the national median. Based on income alone, we weren’t just middle class — we were upper middle class. Yet when it came to money, things weren’t so stable. We had a house with a mortgage that we were paying off slowly. But one month we would have £20,000 in our bank account, then before I knew it, we’d be struggling to pay for car repairs. What happened? We couldn’t put a finger on where the money had actually gone.
What I didn’t realize then was that I suffered from what I now refer to as “middle class mediocrity.” Like so many others, I was raised to believe that all you needed to do was to be smart and get a career. After that, you were pretty much a success.
Except it doesn’t work that way, at least not anymore. These days, people are talking about the inequality gap and the disappearance of the middle class. When I was growing up, the middle class were the people who gained a specialized skill or became managers. This usually required some form of extended study, apprenticeship, or experience. The idea was to get educated, land a job at a good company or government department, contribute that special skill for 40 years, and then have company and government pensions to retire on comfortably. That’s what my dad did. People were looked after. The main thing they usually needed to do financially was pay off their home, something they could generally achieve over the course of a working career.
Now people are on their own. Company pensions have vanished, and government pensions are below the poverty line in many countries. Unfortunately, most people haven’t figured out what that really means. For those who do not understand personal finance, the education and decent income typical of middle class tend to result in a false sense of prosperity and even entitlement. I get it: I am a computer software engineer, and my wife is an accountant . Surely that means that we deserve some of the good things in life, right? A co-worker of mine gave voice to this mentality. He said, “I have a good career with a good income in a prosperous nation: It is my right to not have to think about money.”
It is with this mindset that middle-class families spend more and more on their home, cars, vacations, education for their children, nice furniture and electronics, expensive tablets and smartphones, and more. Not actually having the money in the bank to pay for such items is a triviality; financing is available to people with good incomes, so there is no need to go without. Another friend recently asked me, “What is wrong with a car loan and buying stuff on credit cards?” These are well-educated people, some with multiple degrees. But middle-class mindset simply does not understand how money works.
In an incredibly brave article published in The Atlantic entitled “The Secret Shame of Middle-Class Americans,” author Neal Gabler poignantly and convincingly described this condition from firsthand knowledge. I sympathize with his fear, bewilderment, and even anger. After reading Rich Dad Poor Dad for the first time, I felt all of these emotions and more. It was easy, at first, to deflect the blame elsewhere; I blamed my parents and the education system.
I have a good friend who overcame extreme poverty and an upbringing in an environment surrounded by drug abuse to become a very successful entrepreneur. We would be in the middle of a deep discussion, and I’d become agitated and frustrated. Finally one night when we were talking, I put my finger on it: I don’t have the excuse or baggage of a bad start in life. Instead, I had every opportunity to become successful. Yet into my late-30s, my achievements were average at best. The reality is that I was the epitome of mediocrity trying to convince myself of my own success.
Once I realized this, I was free to act. It is very confronting to realize that you are the result of the decisions that you have made in your life. It is so difficult to accept that many refuse to see it. But this realization has an amazingly powerful corollary: If I am responsible for where I am now, then I am also responsible for what I can achieve in the future. This spirit of self-reliance empowers me to redesign my life in accordance with my dreams.
If you are ready to take charge of your own life, the following three steps will keep you busy for the next few years at least.
Educate yourself on personal finance. Read widely.
There are many great books and articles on personal finance, real estate investing, and more. BiggerPockets and other sites often publish lists of the best books. Use them.
Take control of your own finances.
Get yourself or your family on a budget and start tracking where your money is going. Without this, you can’t tell your money what to do.
Take action to build a better financial future.
It might be through real estate investing, starting your own business, or some other venture. Start the process of building wealth, and you will be thanking yourself before you know it.
The inequality gap is a fissure that runs right through the middle class. It’s not so much that the middle class is disappearing; it’s that it is split on either side of the widening gap. Those who take charge of their financial situations may find themselves among the wealthy. Those who do not will become indistinguishable from the poor. Which side do you want to be on?
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Posted by Eso Akpovwa