The Traditional Path: Education and Employment
I believed I had everything figured out when I entered the workforce after college. Like many, I was taught that hard work, a good education, and a stable job equaled success. The school emphasized subjects like algebra, biology, and literature but never covered financial literacy or how money works.
The Reality Check
I started my career on Wall Street, earning a six-figure salary and feeling accomplished. However, after a few years, I began to question the trade-offs. My job consumed most of my waking hours, leaving little time for personal pursuits, travel, or maintaining a healthy work-life balance. Despite my high income, I lacked control over my time and overall fulfillment.
Discovering Financial Literacy
Seeking answers, I delved into books by financial experts like Robert Kiyosaki and Warren Buffett. I learned that the income we are taught to pursue—earned income—is the least efficient in terms of taxation and time investment. Here’s a breakdown of the three types of income:
- Earned Income: This includes wages, salaries, tips, and other taxable compensation like bonuses and commissions. It is heavily taxed and time-consuming.
- Business Income: Money from the profits of a business you own and operate.
- Investment Income: Earnings from assets like stocks, bonds, and real estate, generating dividends, interest, and capital gains.
The Tax Disadvantage of Earned Income
Earned income is subject to federal income tax, Social Security, Medicare, and often state and city taxes. High salaries mean higher taxes due to graduated income tax schedules. For instance, a single person in New York City might pay up to 51% in taxes on their earned income.
The Advantage of Business and Investment Income
Business and investment incomes enjoy more favorable tax treatments. For example, qualified stock dividends are taxed at 15-20%, significantly lower than earned income tax rates. Capital gains taxes can range from 0-20%, sometimes even allowing for zero tax payments. Businesses are taxed on their income after expenses, unlike employees who are taxed before their expenses.
Case Study: Transitioning from Earned to Business Income
Example: Jane, a software engineer, started an online coding boot camp while working full-time. Over two years, she built a steady client base. Her side business grew, allowing her to reduce her working hours and eventually transition to managing her boot camp full-time. Jane benefited from lower tax rates on her business income and gained more control over her time.
Case Study: Transitioning from Earned to Investment Income
Example: John, an accountant, allocated 20% of his salary to buy dividend-paying stocks and rental properties. Over five years, his investment income grew to cover 50% of his monthly expenses. This passive income allowed him to semi-retire and focus on his passion for writing, benefiting from lower taxes on investment returns.
The Path to Financial Freedom
It’s crucial to transform earned income into business and investment income to shift towards financial freedom. Here are some actionable steps:
- Evaluate Your Income Sources: Create three columns for earned, business, and investment incomes. List and categorize your current income sources.
- Invest Wisely: Allocate a portion of your paycheck to investment vehicles like index funds, stocks, bonds, and real estate.
- Start a Side Business: Dedicate time to build a side business. Examples include creating online courses, selling products on Amazon, or starting a YouTube channel.
Enhance Trustworthiness
Investopedia
- https://www.investopedia.com/
NerdWallet
- https://www.nerdwallet.com/
FAQ
Q: What is the least efficient type of income in terms of taxation and time investment?
A: Earned Income is considered the least efficient because it is heavily taxed and requires a significant time investment. Income from wages, salaries, and tips fall into this category and are subject to federal, state, and sometimes city taxes, which can significantly reduce take-home pay.
Q: Which type of income includes earnings from assets like stocks and real estate?
A: Investment Income includes earnings from assets such as stocks, bonds, and real estate. This type of income generates dividends, interest, and capital gains, and is typically less labor-intensive than earned income.
Q: What percentage of taxes might a single person in New York City pay on their earned income?
A: A single person in New York City might pay up to 51% in taxes on their earned income. This high tax rate includes federal, state, and city taxes, and contributions to Social Security and Medicare.
Q: How are qualified dividends from stocks typically taxed compared to earned income?
A: Qualified stock dividends are typically taxed at a lower rate than earned income. While earned income can be taxed at rates as high as 37% at the federal level, qualified dividends are taxed at capital gains rates, which are 15-20%.
Q: What was the author’s primary realization after working on Wall Street?
A: The primary realization was that earned income is heavily taxed and time-consuming, often leading to a lack of personal time and diminished overall fulfillment, despite high earnings.
Q: What are the three types of income described in the blog?
A: The blog describes Earned Income, Business Income, and Investment Income. Earned income comes from employment, business income is derived from the profits of a business one owns, and investment income is generated from financial assets.
Q: What are the benefits of transitioning from earned to business income?
A: Transitioning to business income can provide more favorable tax treatments and greater control over one’s time. Business owners benefit from tax deductions for business expenses and potentially lower tax rates on profits compared to personal income tax rates on salaries.
Q: What is an example of investment income?
A: An example of investment income is dividends from stocks, which represent a share of profits distributed to shareholders from the corporation’s earnings.
Q: What strategy did John use to transition to investment income?
A: John allocated 20% of his salary to buy dividend-paying stocks and rental properties, which allowed him to build a portfolio that generates passive income over time.
Q: What are the recommended steps to achieve financial freedom mentioned in the blog?
A: The recommended steps to achieve financial freedom include evaluating current income sources across earned, business, and investment income, investing wisely in assets that can generate passive income, and starting a side business to diversify income streams and reduce dependency on earned income.
Conclusion
Earned income, while essential, should be a stepping stone towards generating business and investment incomes. You can achieve greater financial freedom and fulfillment by understanding the tax benefits and leveraging time efficiently. Remember, financial education is crucial, and it starts with taking proactive steps toward diversifying your income sources.
If you have any insights while reading this post, share them in the comments below. For more tips on financial independence, subscribe and hit the notification bell to stay updated. Thank you for reading!
