Types of Income

Robert Kiyosaki, the author of the Rich Dad Poor Dad series of books does a great job explaining the different types of income you can earn and why they differ. The concept is not his alone but I think he does the best job teaching the concept. He calls this the income grid and I recommend reading his first book, Rich Dad Poor Dad, to understand this in detail. To summarize several prominent experts in this area:

Employment Income

This is the first type of income we normally earn and it tends to be the easiest form for most of us. We get a job and are paid for time and effort. Most of us have earned most if not all of our present wealth with this form of income.

The good thing about employment income is that it tends to be less risky than the others. It is against the law to give an employee a paycheck that bounces. If you are paid by the hour or get a salary, you can predict your income to a great degree. The problem with employment income is that you will never be paid what you are worth!

Think about it. A business has a goal to earn a profit. If you are paid $10 an hour to perform your job—it has to be worth more than that to the company. Even if you are a highly paid professional, earning hundreds of dollars and hour, your pay has to be less than it is worth for the company to make a profit.

Employment income has the fewest risks and the lowest rewards. It also provides the least freedom. Generally someone else tells you how much you earn, when you work, how much and when you can take vacation. If you are looking for financial freedom, this is the least likely path to it.

Generally employment income does not cost you anything to acquire. For most people though, education is directly tied to income level. An investment in technical training or college normally returns more then you spend on it. A bachelors’ degree can cost $20-30 thousand but returns hundreds of thousands or more over a lifetime. Masters’ and doctorate degrees cost as much and also generally add $8-10 thousand a year to income potential. The great advantage to paying for an education, it is an asset that can never be taken away from you.

Business Income

If you start a small business, you will be paid what you are worth. At the end of the day the amount of profit you generate is a cruel measure of your effectiveness as a business owner. Yes, bad things happen to good people. Things beyond your control will affect your business, but it is your job as an owner to plan for contingencies.

How does business income differ from employment income? The disadvantages may not appear worth the risk. As a small business owner you have all the liabilities, all the bills and every dollar brought in is ultimately your responsibility. The advantage is that if you are worth $60 an hour for what you do, you have the ability to actually earn that much.

For the majority of small business owners, business income only differs slightly from employment income. If you do not work at your business, it does not bring in any revenue. Thus, you are tied to your business directly by your pocketbook. It tells you when you can go on vacation, when you can quit for the day and how much you will make.

The advantage to business income is the ability to multiply your efforts by hiring employees. You bring in people who can perform duties worth more to your business than you pay them and you generate profits. As this grows, your income as the owner is less dependent on your own efforts and more on the efforts of other people. Eventually, if your business thrives, your income is free from your efforts and you have acquired a level of financial freedom.

The factor that stops most people from starting a business is the cost. The average franchise costs over $100 thousand and many cost much more. A good restaurant can easily cost a million dollars to start. For the small business owner, the cost is not just the start-up costs of the business but the costs to run it. Many people fail to realize that they will be running their business, without pay, until it generates a profit. Most small businesses fail because the owners were under capitalized.

Investment Income

Investment income comes in many forms. You can own stocks and bonds, real estate, precious metals, collectables, to name only a few. This type is the second easiest form to develop. You can take almost any amount of money and start putting into a vehicle for growth.

The initial disadvantage of investment income is that the return is tied directly to the risk of the investment. A bank will give you a guaranteed rate of return on a Certificate of Deposit, but that return is only four to five percent a year. Other types of investment will go up or down in value. You get paid for risking your money, the greater your risk of loss--the greater the potential reward.

The main disadvantage to investment income for financial freedom is that your income is directly tied to the amount you have to invest. For example, if you need $50 thousand a year to maintain your lifestyle and you wanted that to come only from investment income, compare the chart to see how much you need at various annual rates of return:

Annual Rate of Return Amount Needed to Invest
5% $ 1,000,000
10% $ 500,000
15% $ 333,333
20% $ 250,000
According to Morningstar, as of 12/31/2006, the average tracked mutual fund had annualized returns of 6.93% and the best fund had returns of 23.59%.

Another great investment vehicle is real estate. The traditional way to make money is to pay a house, rent it and then sell it after a number of years. The goal is to rent the house for enough to pay your costs of holding the property. Your gain comes in when you sell it later as the property appreciates. The second method is to buy a fixer house, rehab it and sell it for a profit.

The problem with real estate is the money required to purchase and hold or to purchase and rehab the properties. There are a number of books and late night TV shows that claim you can buy houses with no money down and make a profit. It is possible, but these strategies are very risky and take time you may not have to properly research and implement.

I currently run my own stock portfolio and can tell you how hard it is to make 20% or better a year in returns on a continual basis. I also run a small real estate investment company. Even with cash in the bank to buy the properties, it is a full time job for a team of people to make money in real estate investing. It is possible for the individual, but the returns are smaller and the risks greater.

For your financial freedom plan, you should consider investments in stocks and real estate. I personally advocate multiple streams of income for everyone. Diversification of your investment portfolio helps you weather dips in the economy or specific sectors. Investment income is a must for financial freedom. It is income that comes to you with a minimal amount of effort on your part. You can delegate most of the effort for a fee, if you to not have the time or expertise, and gain the advantages of income gained without working directly for it.

Residual Income

Residual income is generated without your direct involvement. Most people know of residual income in terms of entertainment. Every time you buy a book, record or see a movie the artists get a small fee. Many entertainers receive residual checks years after they actually made the record or wrote the book. Other types of residual income include royalties paid for an invention, franchise fees and payments for intellectual property.

Residual income is generally considered the best type of income you can get. Your only involvement year after year is to cash the checks! The downside to residual income is that it generally goes down with time. Sales of books and records tend to go down shortly after publication. The other problem is that you have to do something that generates the residual income. Very few of us are performers, authors or inventors. In addition, franchising a business requires building a successful model that others can follow.