Why is financial resilience so important and what’s the connection to the three types of income?
There is no one-size-fits-all approach to financial, professional and life management. Everyone is different…their circumstances, skills, needs and goals. But nearly every objective or aspiration in life requires capital. Of course, everything requires an investment of time and energy (which certainly is capital of a sort).
But most things — from filling basic needs, to pursuing a personal passion to launching a new business that will change the world — also require financial capital: money. A steady and reliable income is essential to achieving our goals, whatever they may be.
Income stability is a basic need, but financial resilience planning is also critical to getting through life’s inevitable challenges and crises. And while there are tried and tested ways to create strong financial defenses, for personal financial security (as with many things) the best defense is a good offense.
Three Types of Income
Having an understanding of the different types of income gives us more control over the cash flow we already have. It also helps us grow and add new income streams. All cash flow can be bucketed into one of these three types of income.
Most people think that getting a raise is the only path to income growth. But treating these as three different strategies for generating cash flow and growing income also helps diversify and increase financial resilience.
Active Earned Income
The first income type is active earned income. This is usually the first (and easiest) type of cash flow a person starts earning in life. And it’s what most people depend on to cover basic life necessities and begin building their financial future.
Yes, we are talking about a job.
Active earned income is the income derived from a salaried or per-hour job activity. It is any activity that requires you to trade your time for money.
That means this is not just the traditional job that involves going to your place of business, but also includes non-employee contractor positions (so-called gig work). I also put sales roles that may earn commissions versus base salary into this group.
One benefit that active earned income provides is predictability, making it easier to plan a budget and manage expenses. While not as true for commission-based compensation or gig work, the increased volatility in pay works both ways (you can make less or more).
A full time job (in the US) sometimes provides additional benefits, such as health insurance or a 401K match, but these advantages are usually not available to independent contractors.
So, part time and gig jobs may lack the typical workplace benefits, and offer less consistent income. Schedule flexibility (giving you back control over your time) can make up for these disadvantages.
This type of earned income is taxed in the US at 10-35% (depending on your tax bracket) plus contributions to Social Security, Medicare, etc.
While “a job” is the most common and accessible type of income, the biggest disadvantage to active earned income is that it is the least scalable.
Simply put, you cannot trade in more time than you have (and everyone has the same amount of hours per day).
Active Yield Income
The second type of income is termed active yield income. In this framework, active yield income pertains to revenue-generating assets such as a real estate rental property or a business with positive cash flow.
This could include most business income and rental income, as well as royalties (from a patent or book), and also pension income. Active yield income refers to recurring cash flow that we develop and manage ourselves.
The IRS distinguishes this from your job earnings, and refers to it as “passive income.” However, the word “passive” should be avoided as people too easily confuse this with the idea of ‘no work’.
In fact, these income sources require significant work and active effort to launch, grow and maintain.
Yet, once up and running the income they generate is not directly tied to the hours you spend on them as is the case with earned income (a job). Active yield income allows you to decouple your time from your income streams, so you can begin to scale and achieve financial resilience faster.
Another advantage of this income type is that it is generally taxed at a 10-15% effective rate, among the lowest possible.
As an owner or partner in such assets you generally get more revenue or a greater share of profit as well. This makes sense since you took the risk (investing time, energy and money) to build and grow the asset in the first place.
Portfolio Investment Income
The last type of income is portfolio investment income. Common examples include traditional investment income like bond yields or stock and ETF dividends. Strictly speaking, “income” here refers to recurring payouts such as dividends, as opposed to unrealized gains from asset appreciation (like gold or an unprofitable growth stock going up).
Assets in this category are often exchange-traded instruments but can also be alternative or private investments. These can be crowdfunding, angel or venture investments or any other private company investment that generates income.
Unlike the active yield income example above, in these cases the business or asset is managed and controlled by someone else. The US tax rate for such investments typically tops out at 20%.
The key advantage of this type of income is that it scales. Unlike the first and second income type above, portfolio investment income requires little to no time commitment.
Portfolio investment income is essentially out-sourced investment management where, instead of building income, you are buying the income.
Income Stability of the Income Trinity
Now that we better understand the three types of income, let’s consider a simple idea. Triangles come in different shapes and sizes, but what is common to all is that they are naturally rigid and stable.
The three categories of income described above really do encompass all the ways in which we can generate cash flow. Taken together, I like to think of them as the Income Trinity. And, like all triangles, the income trinity provides the ultimate financial strength and stability.
Risk management is a critical part of one’s financial resilience planning. And diversifying income by creating multiple and different types of cash flow is the best way to prepare for those inevitable life challenges.
By incorporating multiple (the more the better) income sources into our financial and life planning we can better diversify and reduce the impact of any one loss of cash flow. Having all three income types — the income trinity — provides excellent diversification and that three-fold strength and rigidity.
This re-framing of the different income types can inform a whole new approach to how we make business and personal finance decisions. And success can take different forms and come in many ways.
But there is no successful strategy for business or life without risk management.
Legendary investor Warren Buffet said it best. “In order to succeed you must first survive.”
This all-important core idea goes beyond just this discussion of the three types of income, and should be a part of everything we do. And a key strategy for risk reduction is diversification.
Diversification Strategy for Income, Investing and Life
This basic precept of diversification (which is one aspect of risk management) is so ingrained into the broader investing and trading culture yet it often gets ignored elsewhere. The discussion above involves income diversification and most folks reading this will already know the importance of investment diversification.
But diversification is something that can be applied in other aspects of life as well. Regardless of where we start or the path we choose, our goals and ambitions will change and evolve along the way. Allowing and exploring a diversity of ideas is a natural (and usually healthy) part of growth.
When we modify and adjust our execution strategy and approach to things we are also diversifying our actions and behaviors. And this personal change or adaptation is not something we should only do when we make ‘mistakes’ or feel we must ‘fix’ ourselves.
Just as adding income streams makes us financially stronger, changing and expanding our perspectives, the experiences we seek and the way we engage with others is a form of diversification that makes us personally stronger and more resilient.
Growing Income Stability
This pretty much sums it up: growing income (and income diversification) creates income stability. The income trinity is a good way to assess your income options and is useful when considering how to allocate your precious time and energy (to execute on those choices).
And growing income stability through diversification is an essential part of financial resilience planning.
We must be able to adjust course and adapt as we go because risks are a natural part of life. Crises will happen. But it becomes much easier to pivot in response to adversity when we have already prepared ourselves through diversification.
When you consider the three types of income, which new cash flow option will you try next? And don’t worry if they don’t all work out. Adapting and changing comes with the territory (and is part of life).
Growing income is good but diversification is the goal, so more and varied is better. Income diversification will help you build financial resilience and be prepared for whatever is ahead.