It is said that the average rich person have around seven streams
of income whereas the average person typically have only one source of income. If
you take a look at the income of rich person, they have more than one stream of
income generating cash flow.
All types of income which i will explain below are not same. Some of
the source of income are active some are passive, some are of mix of both, some
are highly taxed and some can be leveraged to pay low or not have to pay any
tax at all.
Here, I am going to explain the 7 different types of income than the
average rich person have in their portfolio.
1)
Earned Income
One of the most common sources of income is earned income or income
you earned from job. This income includes the income earned by employee or worker
from the employment which also includes the income earned by the CEO who is
still a employee of a company.
Other professionals like doctors, engineers, chartered accountant,
freelancers etc. are also included in this category, since they exchange time for money which is what
is called active income. Earned income is typically the starting point for many
self-made millionaires. It's a good way to get started especially if your job
allows you to provide time for yourself and your family but the dangerous part
is staying in this category for long time because this type of income use your
time which you have a limited amount. Every person have only 24 hours in a day
like everyone else, so there is always a ceiling on how much money can be made by
staying in this category.
This is also one of the highest taxed forms of income taxes as
this category in Nepal can go all the way up to 36% of your income. Some people
in this category pay almost 1/3rd of their earnings in taxes depending
on their income.
2)
Profit Income
This is income produced by selling products or services for more than
it costs to produce or to purchase the product or services. The process of
earning profit income arises when the person earning salary being an employee is
converted into an entrepreneur.
In the past starting a business required a significant investment
to produce or to purchase the products but it has become much easier in recent
years with the help of the internet. Whether
you sell a physical product or a digital product, if you sell a product for a
higher price than it takes for you to make or buy them you are making profit
income.
This can be active income or passive income depending on your
business model. If you make product or services by yourself and sell them, then
it's more of an active income and a little more difficult to increase the scale
of business. However, if you create the product and you have a manufacturer
created for you or you make a digital product it has the potential to increase
the scale which will become a passive form of income.
There are two types of profit income namely individual or small-scale and another is business or highly scalable. The income will be individual or small
scale is when you either create the product yourself or sale products through
ecommerce such as daraz, amazon, choicemandu or facebook marketplace and that
is a great way to add an additional source to your income.
The scalable profit income comes from establishing a business and
having a manufacturer produce your products instead of doing it yourself. In this
way, you can free your time to focus on other aspects of your company like
sales or marketing.
Another recent example of highly scalable business is using digital
products which have enormous capacity of scale. Digital products are highly
scalable because they do not require storage, shipping cost or even manufacturing.
These two types of profit income are taxed differently. If you are
an individual creating your own physical products in a small scale, you will be
taxed the same as earned income but if you build a business you might be able
to take advantage of many tax breaks by forming a company. The tax rate for the
companies in Nepal is 25% of taxable income which is lower than the income
earned by individual through proprietorship firm.
3)
Capital Gains
Capital gains income is generated when an asset that appreciated in
value is sold at higher price than purchase price. The most common capital
gains generated from real estate and stocks, but there are many other assets.
An investor can own shares that may appreciate each year, but the investor does
not incur a capital gain tax on the shares until they are sold.
Capital Gain = Sale Price – Purchase Price
For example, if you bought a real estate property for 50 lakh and
you sold it for 75 lakh then you made capital gains income from the sale of
real estate property is 25 lakh. Another example is, if you bought 1000 shares
of a company at 200 per share and you sold all the shares at 300 per shares,
then you made 1 lakh in capital gains.
This is different than profit income because here you are not
buying or making a product and selling it for a profit instead you have assets
that appreciated in market value which you don't have much control over the
value increase.
The great thing about capital gains is that taxes paid on this type
of income are much lower than most other forms of income. Capital gains are mostly
taxed between 5% to 15% depending on the nature of amount earned. Capital Gain
tax may go down to 0% in some cases on sale of land and building by resident
individual in certain conditions.
4)
Interest Income
You make interest income by earning interest by lending your money
or from banks deposit. I don't really mean lending money to your friends as
this is typically not a good idea but there are other few ways to earn income
from depositing money at banks or lending money to companies in form of a debentures
or purchasing the government bonds issued by Nepal Rastra Bank which are highly
safe to invest.
The rate of interest on fixed deposits is normally above the rate
of inflation which is around 7% to 10% per annum. Government bonds are not the
most lucrative as many of these have interest rate between a 5% to 8% per year.
This is a passive form of income because in most cases your active involvement
isn't needed.
5)
Dividend Income
Dividend income is that income when you invest in stocks that pay
part of their profits to their shareholders. When you buy a stock in a company
you become a shareholder of that company. Whenever the company where you
invested in reports profits, they will send a cheque to their shareholders.
Typically every quarter as a shareholder you are part owner of the
company so you get a portion of the company’s profits when such company distributes
the dividends. Taxes at the rate of 5% is charged on dividend income which are
to be distributed to the shareholders and it is in the form of final
withholding tax.
6)
Rental Income
Rental income typically comes from buying real estate and renting
it out to other people. It does not necessarily have to be home rentals as this
can also include commercial properties that can be rented to businesses or industrial
real estate which is rented to manufacturers.
Rental income does not have to come from real estate specifically
there are other ways to create rental income at a smaller scale. For example,
many people lease the equipment for various industries or their cars or instruments
etc. Rental income is any income produced
by leasing a property to somebody else in exchange for money.
7)
Royalty Income
This type of income is earned when you continue to get paid after
your work is done. Where you work in a movie that continues to be watched or
you wrote a book that continues to sell. If you built a youtube channel that continues
to be viewed a regular form of income will be generated which can also be
termed as royalty income.
Royalty income is also generated when you make money by letting
other people use your ideas or properties to make money such as music or books.
For example, music artists allow streaming services and recording
labels to produce and sell their property to the public therefore making
royalties every time a song is played or sold or when someone buys a record. Another
example is when a publishing company prints and distributes a book as long as
people keep buying the book the author continues make money.
There can be multiple royalties collected from the same property. A
great example of this is the author JK Rowling, she did not only make royalties
from her book sales but also from the adaptation of her books in movies and
merchandise based on her characters. Even though it's been 20 years since the
first Harry Potter book came out JK Rowling the author still collects royalties
as long as people are buying merchandise, renting or streaming the movies or
buying the books she gets royalty payments because those products are based on
her original property
Conclusion
Most of us know only one or two ways of creating income but
knowing the different types of income and how they are made gives us a better
opportunity of adding different sources of income into our life. There are also
various other sources of income such as pension, social security benefits etc
which has not been discussed. We should ask ourselves which source of income
sounds the best to you and which one will you add to your income in next future.
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