3 Types of Income to Build Wealth: Earned, Passive & Investment Explained

Types of income fall into three main categories: earned income, passive income, and portfolio income. Understanding these types of income helps manage finances and plan wealth-building strategies.

What Is Income?

In general, income is money you receive from working, providing goods or services, or investing. In other words, it’s any money you gain that you can put in the plus or revenue column of your budget. It’s also commonly measured in cash. Your paycheck may be the first source of income that comes to mind, but other types of income include tips and commissions, profits from selling goods or providing services, interest and dividends from investments, gifts and inheritances, government benefits and tax refunds, and withdrawals from retirement funds.

Type 1: Earned Income - Active Work For Money

Earned income is money you earn by working—either for yourself, someone else, or a business you own. It’s also called “active income” because you actively perform a service for it. This represents the most straightforward among the three types of income and typically forms the foundation for building wealth in early career stages.

If you work for a company—including small business or large corporation—your employer may pay you an hourly wage or salary. Earned income could also include bonuses and extra pay. For example, taxi drivers and restaurant servers can earn tips, while salespeople can earn commissions based on performance.

Common Earned Income Sources

Salary and Wages: Fixed or hourly compensation from employer for work performed

Tips and Commissions: Variable income based on sales or service quality

Bonuses: Extra pay tied to performance or company milestones

Self-Employment Income: Earnings from running your own business or working as independent contractor

Gig Work: Temporary or short-term jobs like freelance writing, delivery driving, or rideshare

Gigs represent growing segment of earned income. People who want independence, self-employment, or part-time work increasingly consider gig work. These side hustles are often temporary or short-term jobs performing single tasks on demand. Musicians, babysitters, freelance writers, and delivery drivers are all examples of gig workers.

Earned income characteristics include being typically used by workers to buy assets that can later generate investment and passive income, being taxed as personal income with rates increasing as earnings grow (up to 37% top federal rate for 2024), and sometimes being difficult to distinguish from other income types for business owners or investment professionals.

The challenge with earned income is its limitation: you can only work so many hours in a day, and there’s a ceiling to how much any employer will pay for your time. This ceiling motivates financially savvy individuals to develop passive and investment income streams supplementing earned income.

Type 2: Passive Income - Money Works For You

Passive income is considered money earned without actively working for it. That’s why it’s also called unearned income. Rental income and income from royalties and limited partnerships are prime examples. This represents one of the most attractive types of income because it continues flowing even when you’re not actively working.

Other examples of passive income include alimony, child support, unemployment benefits, Social Security benefits, and worker’s compensation. However, the most wealth-building forms of passive income come from assets you control: rental properties generating monthly rent, royalties from books, music, or patents you’ve created, and limited partnership distributions from businesses you’ve invested in.

Money earned from assets you own that generate recurring payments without being sold:

Rental Income: Payments from tenants using property you own

Royalties: Income from intellectual property like books, music, or patents

Interest: Payments from bonds, savings accounts, or fixed-income investments

Dividends: Distributions from stocks you own, paid by companies

Limited Partnerships: Profit distributions from businesses you’ve invested in

Passive income characteristics include being taxed as personal income and added to your total earnings at tax time, playing key role in retirement or long-term wealth building, shifting to investment income if you eventually sell the asset generating payments, and generating ongoing income with limited involvement depending on the asset (dividends or royalties typically require less upkeep than rental properties).

The reality is that passive income often requires substantial upfront work or capital. Rental properties demand down payments and ongoing maintenance. Creating royalty-generating intellectual property requires months or years of creative work. The “passive” descriptor refers to income generation phase, not the asset acquisition or creation phase.

Type 3: Portfolio Income - Investment Returns

Portfolio income comes from your financial portfolio—a collection of your monetary assets. It’s also called investment income, which can include interest, dividends, and capital gains. This represents the third major category among types of income and often receives preferential tax treatment compared to earned income.

Income can come from bank or credit union that pays interest on account balances. For example, you can earn interest on savings accounts, money market accounts, and certificates of deposit (CDs). Keep in mind that the amount of money you make in interest can vary based on rates and balances.

You could also earn income by investing. You can typically invest in bonds, stocks, and mutual funds. When you buy bonds, you’re essentially loaning money to corporation or government in exchange for them paying you interest. When you buy stock in company, you’re part owner in that company, so you can share in its profits. Similarly, you can make money from mutual funds, which pool money from investors to make and manage investments.

Think of dividends as payday on your investments. When company makes money, it can pay portion of its profits to shareholders. Corporations commonly pay dividends in cash, but you can also receive more stocks or other assets, such as property. These dividend payments represent return on your investment without requiring you to sell shares.

When you sell something for more than you paid for it, the difference is called your capital gain. With financial investments, you can earn capital gains when you sell stock or cash out pension fund whose value has increased since you bought it. For example, buying stock at $50 per share and selling at $75 generates $25 per share capital gain.

Portfolio Income Characteristics

Includes profits from assets sold for gains: Capital gains when selling appreciated investments

Sometimes difficult to distinguish from earned income: Especially when compensation involves equity like stock options

Usually taxed as capital gains: Typically lower rates than earned income (20% versus 37% top rate for 2024)

Applicable to unusual items: Comic books or artwork sold at profit also generate capital gains

The tax advantage of portfolio income represents significant benefit. Long-term capital gains (assets held over one year) are taxed at maximum 20% federal rate for high earners, versus 37% top rate for earned income. This differential incentivizes investment and wealth accumulation through portfolio growth rather than purely earned income.

How The 3 Types of Income Work Together

Each type of income plays different role at various stages of your financial life. When you’re starting your career, earned income covers daily expenses and helps you begin building wealth. This active income provides capital for purchasing assets that generate passive and investment income later.

Over time, investment and passive income provide additional stability and support long-term goals such as retirement. Understanding how these types of income work—and how they’re taxed—can help you make more informed financial decisions. The wealthy typically maximize all three income types simultaneously: maintaining earned income from businesses or professional work, building portfolio income through stock and real estate investments, and developing passive income streams from rentals or royalties.

The progression often follows predictable pattern. Young professionals focus almost entirely on earned income, working long hours to maximize salary and bonuses. As they accumulate savings, they begin investing, creating portfolio income through stock dividends and capital gains. Eventually, some purchase rental properties or create intellectual property, establishing passive income streams requiring minimal ongoing effort.

By retirement, the ideal scenario involves minimal earned income (perhaps part-time consulting) with living expenses covered by combination of passive income (Social Security, pensions, rental income) and portfolio income (dividends, interest, strategic capital gains). This diversification across types of income provides resilience against any single income source failing.

Tax Implications Across Types of Income

The IRS treats different types of income differently for tax purposes. According to the IRS, most income is taxable unless specifically exempted by law. Taxable income can be money, property, goods, or services, and must be reported on your tax return.

Earned income faces the highest tax rates, with federal brackets ranging from 10% to 37% depending on total income. Additionally, earned income is subject to Social Security and Medicare taxes (FICA), adding another 7.65% for employees (15.3% for self-employed individuals). This combined tax burden can exceed 50% in high-tax states for top earners.

Portfolio income receives preferential treatment. Long-term capital gains (assets held over one year) are taxed at 0%, 15%, or 20% depending on income level—substantially lower than earned income rates. Qualified dividends also receive capital gains treatment. However, short-term capital gains (assets held under one year) are taxed as ordinary income, eliminating the tax advantage.

Passive income typically gets taxed as ordinary income, similar to earned income. However, certain passive income like qualified dividends may receive preferential rates. Rental income offers unique tax benefits through depreciation deductions reducing taxable income even while cash flow remains positive.

Understanding these tax differences helps optimize your income mix. High earners often prioritize investment income over earned income not just for passive benefits but for dramatic tax savings. A $100,000 capital gain taxed at 20% yields $80,000 after-tax, while $100,000 earned income taxed at 37% plus FICA yields approximately $55,000 after-tax—a $25,000 difference.

Discretionary vs Gross vs Net Income

Beyond the three main types of income, understanding related concepts helps manage finances effectively. Gross income is the total amount of money you earn from wages, tips, commissions, and bonuses before any deductions. Net income is the amount left over after taxes and deductions, like health insurance or retirement contributions. This is your “take-home pay”—the actual money deposited in your account.

Discretionary income is the portion of income within your budget you have left to invest, save, or spend after you’ve met your necessities. For example, you may use discretionary income on travel and entertainment. This represents the funds available for lifestyle choices beyond survival needs.

These distinctions matter for financial planning. Budgets based on gross income lead to overspending because they ignore taxes and deductions. Accurate budgeting uses net income as the baseline. Discretionary income then determines how much flexibility exists for savings, investments, or enjoyment without compromising necessities.

Building Multiple Income Streams Strategy

Financial advisors increasingly recommend developing multiple streams across all types of income rather than relying solely on earned income. This diversification provides several benefits: income stability if one stream disappears (job loss, investment decline), tax optimization by mixing income types with different tax treatments, wealth acceleration by reinvesting passive and portfolio income into additional assets, and retirement security with income continuing after earned income stops.

The strategy typically involves using earned income to purchase income-generating assets. A portion of salary goes toward stock market investments generating dividends and capital gains. Another portion funds down payment on rental property creating passive income. Excess cash flows into high-yield savings generating interest. Over years, these additional income streams grow, eventually supplementing or replacing earned income entirely.

FAQ

What are the 3 main types of income?

The three main types of income are earned income (wages, salary, tips from active work), passive income (rental properties, royalties, partnerships generating money without active involvement), and portfolio income (interest, dividends, capital gains from investments). Each serves different purposes in wealth building.

Which type of income is taxed least?

Portfolio income typically faces lowest tax rates. Long-term capital gains are taxed at maximum 20% federal rate versus earned income’s 37% top rate. This 17 percentage point difference makes investment income significantly more tax-efficient for wealth accumulation.

What is the difference between earned and passive income?

Earned income requires active work—trading time for money through employment or self-employment. Passive income generates from assets you own (rental properties, royalties, dividends) without active involvement. Passive income continues flowing even when you’re not working.

How do wealthy people use all 3 types of income?

Wealthy individuals typically maintain earned income from businesses or professional work, build portfolio income through stock and real estate investments, and develop passive income streams from rentals or royalties. This diversification provides stability, tax optimization, and accelerated wealth building.

Is Social Security earned or passive income?

Social Security is classified as passive income because it’s received without active work, though it was earned through years of employment contributions. For tax purposes, Social Security may be partially taxable depending on your total income level.

Which type of income should I focus on first?

Start with earned income to cover living expenses and build initial capital. Once you have savings, invest in portfolio income assets (stocks, bonds) that are liquid and require minimal management. Finally, develop passive income streams (rental properties, businesses) requiring more capital and effort but providing ongoing cash flow.