The 3 Different Types of Income
A dollar is a dollar, right? Well, not quite…because not all income is created equal.
Most people are not aware of the different ways to make money. But how you make your income matters.
In this article, we will dive into the three types of income (active, portfolio, passive) and explore what each type of income represents, how they are earned, and how they are taxed.
Active Income
Active income is the money you earn from your job. This is the money you make as a physician. For many, active income serves as the primary source of income, providing the means to cover daily living expenses, bills and financial commitments.
Active income is linked to the amount of time and effort invested. In this context, the more hours you dedicate to your job or business, the greater your active income.
While active income provides regular cash flow, it has certain limitations. Fixed working hours and income caps restrict earning potential. Time and money are intricately linked. To earn more money, you have to put in more time or increase the value of your time.
Active income is the most highly taxed of all three types of income. As we see from the table below, most physicians are taxed at the 32%, 35% or 37% brackets. If you think about it, any additional money you earn is actually being devalued. For example, every dollar earned over $578,125 (as a single person) is worth 2% less, since it’s taxed 2% higher than the previous tax bracket.
2023 Ordinary Income Tax Brackets
| Tax Rate | Single | Married Filing Jointly | Head of Household |
| 10% | $0 – $11,000 | $0 – $22,000 | $0 – $15,600 |
| 12% | $11,001 – $44,725 | $22,001 – $89,450 | $15,601 – $59,850 |
| 22% | $44,726 – $95,375 | $89,451 – $190,750 | $59,851 – $95,350 |
| 24% | $95,376 – $182,100 | $190,751 – $364,200 | $95,351 – $182,100 |
| 32% | $182,101 – $231,250 | $364,201 – $462,500 | $182,101 – $231,250 |
| 35% | $231,251 – $578,125 | $462,501 – $693,750 | $231,251 – $578,100 |
| 37% | $578,126+ | $693,751+ | $578,101+ |
Portfolio Income
While active income is earned by exchanging time for money, portfolio income is made through capital gains.
Capital gains is the profit you receive from selling an investment. For instance, if you bought a stock for $100 and two years later, you sell it for $250, the $150 in profit is known as capital gains.
Portfolio income does not require active involvement in the day-to-day operations of the invested assets. Instead, it relies on the appreciation and performance of the investments.
However, the value of portfolio income can fluctuate based on market conditions and the performance of the underlying assets. For instance, stocks may experience price volatility, impacting the value of dividends or capital gains.
Portfolio income is taxed at a lower rate than active income. Long-term capital gains (assets held for over a year) are currently taxed at either 15% or 20%.
2023 Long-Term Capital Gains Tax Brackets
| Tax Rate | Single | Married Filing Jointly | Head of Household |
| 0% | $0 – $44,625 | $0 – $89,250 | $0 – $59,750 |
| 15% | $44,625 – $492,300 | $89,251 – $553,850 | $59,751 – $523,750 |
| 20% | $492,301+ | $553,851+ | $523,751+ |
Passive Income
Passive income…my favorite type of income! Passive income encompasses earnings from activities in which the earner is not materially involved. It represents a shift from the traditional notion of trading time for money.
Instead, passive income streams are designed to generate ongoing returns with minimal active participation once they are established. Examples of passive income include rental income from real estate properties, royalties from books or music, and profits from limited partnerships or businesses in which the investor has limited involvement. The appeal of passive income lies in its potential to create financial freedom and reduce reliance on active labor.
Building passive income streams often requires upfront investment or effort, and the returns may take time to materialize. For instance, acquiring rental properties involves initial capital investment. Similarly, creating and marketing intellectual property may require substantial time and effort before royalties start flowing. However, once established, passive income provides a consistent stream of cashflow.
Passive income is taxed less than both active and portfolio income. In the example of real estate, through depreciation and, if you qualify, Real Estate Professional Status, it’s possible for the income to be taxed at 0%.
Conclusion
Understanding the different types of income—active, portfolio, and passive—is crucial for effective financial planning. Each type of income has different tax implications. As physicians, we are fortunate to earn a high active income. However, the money we make is directly linked to the time spent at work.
It’s important for physicians to find ways to convert their active income to portfolio income, and even better, passive income. This is the key to breaking the connection between your time and income, and achieving true wealth.
