Income

Part One: Types of Income

For the more honest citizens of the world, there are three categories of income:

• Earned income is the wages you earn working for yourself or someone else:
• Passive Income is income derived from enterprises in which you are not actively involved: and
• Portfolio income is the earnings from your savings and investments.

Each form is income is taxed differently. To be independently wealthy, you want your money to work for you rather than you having to work for your money.

Earned Income

This is the form of income most of us are familiar with. You either work for yourself or some one else. The money you earn is subject to taxation. What’s left afterwards is your spendable income.

When you work for someone else, the idea is that you are contributing to the bottom line – making the boss or the shareholders wealthier. Depending on your skills or union affiliation, you may have some say over how much you make.

But you are almost always expendable – they will be somebody else who can take your place, sometimes for lower wages. You and your employer are aware of this and this in a way governs how you approach your job and limits how much you earn.

Unless you really love what you’re doing, you do just enough to keep your job, your promotions and bonuses. If you don’t, you will quickly find yourself replaced with someone more ambitious. On the other hand, your boss will pay you just enough to keep you from walking out the door.

If you work for yourself, you set the rules and reap the benefits, if any. Just like employees, business owners have to face competition and adjust their practices accordingly.

You will face cost and pricing pressures, employee (if any) and customer dissatisfaction. But, if you are good at what you do and preserve through the bad times, the sky’s the limit.

You will have built a valuable asset. You will also enjoy tax benefits that those who work for others will not have.

A business that is properly run for profit, doesn't have to make any. And, depending on how your business is structured, you can offset business losses against other ordinary income.

For example if a husband makes a nice living that results in a huge tax burden, the wife might start a work at home business that creates losses to offset that income.

Another nice thing about a business is the ability to convert what would be after-tax expenses, into business deductions. For example you could pay your family's health insurance through your business, which will deduct it from gross income. This can generate big savings.

Consult a CPA and make sure that you structure your business correctly and follow all IRS regulations.

If done correctly this will free up more money to save and invest.

If you are a successful wage or self employed business earner, you should be resisting the temptation to spend your earnings and save your money so it works for you.

That’s where the other forms of income come in.

Passive Income

This is usually generated by rental properties you may own. But you can also get passive income from limited partnerships that are usually set up to throw off tax benefits.

It’s called passive because you are not an active participant in the enterprise. It used to be that wealthy folks would buy rental properties, not so much to earn money, but rather to create losses to offset their other income.

Passive income was the government’s answer to that problem. Losses from passive income can no longer be used to offset earned income, be it from wages or investments.

However, passive income can be used to offset passive gains. So partnerships are set up to take advantage of this. This is a complex subject, well beyond the scope of this article.

If you are in the upper income brackets, a Certified Financial Planner or CPA can advise you whether these vehicles would help you in any way.

Watch out for high fees and expenses, as well as outright fraud.

Portfolio Income

Most of us will take our savings and invest them either in savings vehicles, such as savings accounts or CD’s or in the stock market.

Savings accounts and CD's are the safest investments in that they are federally insured and in that you can’t lose your principal.

However they are taxed at your ordinary tax rate and rarely keep ahead of inflation.

Mutual funds, stocks and bonds have had a historically stronger rate of growth and usually outpace inflation. They generate dividends as well as capital gains or losses. Dividends are classified in different ways and carry different tax rates.

A capital gain or loss is the difference between what you paid for an investment and what you sold it for. If you made money and held the investment over a year, the gain is presently taxed at 15% - who knows for how long. Capital losses can be used to offset capital gains and can be also used to offset other income, up to $3000.

As with everything contained in the tax code, there are all sorts of exceptions and exclusions, so consult a tax expert for the exact rates you might pay.

If you keep your money in tax shelters, you don't have to worry about any of this. You do lose the benefit of the use of capital losses, but don't have to worry about things like short term capital gains.

In the long run, your money will grow faster with taxes out of the picture.

Part Two: Make Your Money Work

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