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Are You Leveraging These 3 Types of Income to Maximize Your Personal Finances?

Time To Read 7 MIN READ

Are you taking full advantage of all 3 types of income? If not, you could be missing out.

Earned income, capital gains income, and passive income all play different roles throughout your financial journey, from taking care of your monthly expenses to reaching your long-term goals with confidence.

This guide covers each source of income to help you maximize your personal finances through every stage of your life.

What are the 3 types of income?

The 3 types of income are:

  1. Earned income
  2. Capital gains income
  3. Passive income

As you move through life, the balance between these types of income will usually shift. Most people start out making earned income by working for a living, transitioning into a mix of capital gains income and passive income over time.

Why? Because instead of trading your labor to make money, capital gains income and passive income put your money to work for you.

You build up these income sources by investing in them over time. That’s why it’s important to set goals for your financial journey now, investing in your future along the way.

What is earned income?

Earned income is the money you get from working, whether for yourself or for someone else. The most common source of earned income is a job—including your salary, wages, and tips. 

If you work for yourself in your own business, or if you make money from a hobby or side gig, that’s also earned income. It’s all money you’re making for work you’re doing.

People start out using earned income to make a living because you can get a job even if you don’t have any savings. That might sound obvious, but it’s an important way to think about money.

At some point, you’ll want to stop working for a living. When you do, you’ll need other sources of income. That’s why it’s important to think about all three kinds of income ahead of time.

How to start moving away from earned income

Arguably, the most important move you can make for a healthy financial future is to make sure you’re not spending every dime just living month to month.

The more you can save toward the future, the easier that future will be. These 3 tips can help you take maximum advantage of your earned income, setting you up for the transition to other sources of income later:

1. Maximize your 401(k)—and claim those matching funds

If your job provides a 401(k) retirement plan, make sure you understand how it works. Most employers will match a percentage of your 401(k) contributions, up to a certain amount.

For example, an employer might match 50% of your contributions, up to 6% of your salary. In other words, if you earn $5,000 per month, your company will give you as much as $300 extra each month toward your retirement as long as you’re contributing enough to claim it.

Since your employer is only matching half of your contribution in this example, you’d have to contribute $600 each month to get the full $300 extra. If that’s more than you can afford, set that as your first goal: working toward contributing enough to claim those full matching funds.

On the other hand, contributing too much to your 401(k) can also leave money on the table because of the annual limits on these kinds of accounts. You could reach the contribution limit before claiming the full potential of your employer’s matching funds.

Check with your human resources representative to make sure you’re taking full advantage of your employer’s plan.

2. Consider buying a home instead of renting

Paying rent every month gives you a place to live, but it doesn’t do much for your future. Once you spend that money, it’s gone.

When you buy a home and start paying down your mortgage, you’re building equity along the way. To calculate your equity, take the current market value of your home and subtract whatever you still owe on the mortgage. As you pay down the mortgage, your equity grows.

It’s not income in the sense of putting money directly in your pocket every month, but it still helps you make that income transition:

  • As you build equity, you can borrow against that equity to make other investments
  • Once your mortgage is paid off, you can save or invest the monthly amount you used to spend on your house payment
  • If you ever need to, you can sell your house, pay off the mortgage, and keep the remaining equity, essentially converting it into cash

3. Stick to a budget and build your savings

Remember, capital gains income and passive income use money to make money. The more you save, the more you’ll have to work with when the time comes.

  • Start by building an emergency fund so you’ll have short-term cash available in case of unexpected expenses.
  • If you want to save even more, building a budget is a great way to find places where you can cut back on your spending without giving up the things you love.
  • You can also do more with your money if you pay down expensive debt quickly, like credit card balances.

Building up your savings and your retirement fund is an important step toward your transition into capital gains income and passive income.

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What is capital gains income?

Capital gains income is the money you make from buying and selling investments. By definition, it’s a kind of investment income, putting your money to work for you.

Any investment is a risk, especially in the short term, but, at least historically, stock market fluctuations have tended to even out over time, providing long-term returns.

If you have a retirement plan like a 401(k), you’ll usually have some choice when it comes to investing those funds. For many people, that’s the first step into capital gains income.

Much like buying your own home, the value of your investments is very real, but you can’t take your stock to the store and use it to buy groceries. You’ll have to sell those investments, or borrow against their value, if you want to use that money for other things.

You’ll also usually incur a penalty if you withdraw funds from your retirement account early, but there are significant tax advantages if you leave the money in your plan until you reach retirement age.

What is passive income?

Passive income is a source of income in which you receive funds regularly without any special effort, freeing you to do other things with your time.

As with earned income and capital gains income, the IRS has a specific definition of passive income. That definition includes only 2 things:

  1. Income from a business in which you don’t materially participate
  2. Income from rental properties

If you’re thinking about the 3 kinds of income from a tax-planning standpoint, that’s an important distinction.

However, if you’re considering the 3 types of income in planning your retirement cash flow, you’ll also want to include other forms of income that are just as passive, even if they’re taxed differently.

Examples of that broader definition include:

  • Interest from savings accounts
  • Dividends from investments
  • Social Security payments
  • Pension payments

In each case, these sources of income are passive in that you receive cash on a regular basis without having to do anything special to get it.

The more income you build from passive sources, the less you’ll have to dig into your capital investments for your day-to-day needs. 

Final thoughts

The financial journey laid out in this guide is what retirement planning is all about: setting you up to enjoy your retirement with confidence.

Software like Quicken can help you track your income, better manage your spending, build your savings, plan your investments, and prepare for your financial future.

The Lifetime Planner in Quicken for Windows even lets you model what-if scenarios to see how the choices you make today could impact your retirement.

With the right planning, the retirement income you design will support your lifestyle indefinitely, letting you do all the things you’re looking forward to — not just for years, but for decades.