MIND YOUR BUSINESS: The Three Types of Income

I’ve been getting the same reaction enough times for me to conclude that most of us only know one type of income – the salary of an employed person.

Not surprisingly, because most of us only receive one type of income. And most of us encourage our children to aspire for the same type of income. It should not also surprise us that many of our countrymen line up for the same type of income.

“At least I know one type of income,” reasoned someone in the audience in one seminar. “Now you can tell us the other two.”

“Yes, I will surely tell you, but let me tell you first, that the type of income you know and are earning now should tell you where you are going financially. That should lead you to think what types of income the fewer but richer people in our country earn,” I said.

“But let us first explore the first one that you know.”

“The first type of income, the one most of us are familiar with, is called Active Income. It is income that is earned only when you work. The expression ‘no work, no pay’ may describe this type of income. Active income is the salary earned by an employee, the business income of a small business owner, or the professional fee of a self-employed professional such as a lawyer, a doctor or a consultant.

“This income is dependent on our physical abilities and full physical presence. As we grow older, our ability to earn such income diminishes. Because Active Income mostly comes in the form of salary or wages, income taxes and impositions such as SSS, GSIS and Philhealth payments are deducted from this type of income before it even reaches our pockets.”

The audience nodded knowingly.

I continued:

“The second type of income is somewhat the opposite of Active Income. It is called Passive Income, and unlike the first type, it is earned without you working directly for it.

“This type of income is earned by a business owner, for instance, whose business is being run by a management team which he employs. The management team, usually headed by a Chief Executive Officer or a General Manager, runs and manages the business for the owner, who may or may not choose to work.

“Another income of this type is rental income from a residential or commercial property. The landlady’s staff comes at the end of the month to collect the rent for her. The money comes in even when she is not present,” I added.

“So, knowing this, Passive Income is the one desired by smart business owners. Moreover, if the business is in the form of a corporation, the law allows the owner to deduct more business expenses from the income before it is taxed. While single proprietorships can also deduct business expenses, the business income is not separate from the owner’s income, and is thus taxed at the same rate as a personal income. In general, a corporation can play around with its income more than a single proprietorship can.

“This flexibility and tax savings enable corporation owners to reinvest more money in the long run. Passive Income and a corporation are some of the reasons the smart rich become richer, legally.

“Passive Income can also come in the form of royalties from intellectual property assets such as a patent on an invention, a book published, a movie created, or a song composed.”

Sensing that I have most of the audience’s attention, I continued:

“The third type of income is income that comes from paper investments. It is called Portfolio Income, which could come from paper assets, such as shares of stocks, bonds, treasury bills, or deposits.”

“So you mean if I buy shares of stock of San Miguel Corporation or Jollibee, I now have Portfolio Income?,” a participant interrupted.

“Well, Portfolio Income does not come with just any company stock, bond or any paper asset. That stock has to give you dividend, that bond or bill has to give you a yield, and that deposit has to earn you interest.

“And that dividend, yield or interest should not just be of any amount or rate. They should be higher than the inflation rate. In other words, the rate of income from paper assets should be higher than the rate that prices of goods are increasing. Otherwise, your paper investment is, in real terms, losing value. Meaning, the income is not ‘real.’”

Sensing some rising eyebrows in the audience, I resisted going into the technical details of specific paper investments.

“So, as you have seen, of the three types of income, the Passive and Portfolio Incomes are the ones that could make a person’s financial life better over time.”

“Okay, so how can we earn these other types of income?,” a young man asked, getting impatient.

“Well, the first step is to increase your financial intelligence. Meaning, to learn how and where to find assets that bring about these incomes. And also, learning how to invest in such assets,” I explained.

“So how can we acquire such assets? Will you tell us how?,” the young man persisted.

“I might try to, but perhaps in another session,” I said, looking at my watch.