I am very confident this post will give you many Eureka moments because it talks about things most people aren’t aware of.

Also, if you really pay attention, the content of this email will keep you up at night for at least the next 2-3 days (in a good way of course).

See, if you are in the middle class, the only type of income you might have heard of is “salary” or “commissions” or “part time wages”.

You wouldn’t have heard of people making money through dividends, royalties, rent etc.

This is because all these “other” income sources are not at all related to the middle class.

In fact, I would go so far as to say that only 1-5% of the world’s population effectively earns income through dividends, royalties and rent.

But let’s back up for a minute.

Before we proceed further, I have to mention another important point: Not all incomes are equal.

There are 3 types of income that you can earn:

 

  1. Earned income: This is what you earn as a result of your labor. This can include salary, overtime, commissions etc. Most of your family members make money through this type of income because they either have a job or they are self-employed (think a doctor, lawyer or chiropractor). “Earned income” is taxed at the highest levels, which means that the government wants a bigger chunk of your cash when you earn it.

 

  1. Portfolio income: This income is also called capital gains income. People earn this type of income whenever they sell a land, property, stock etc. for more than they paid on it when they bought it. Portfolio income is taxed at a lower rate than earned income. The issue with portfolio income is that you have to sacrifice the asset to get this income which is not a good strategy most of the times.

 

  1. Passive income: This is the most tax efficient type of income available, probably because it takes a lot of financial intelligence to generate it. For example, if you purchase an investment property, put it up for rent and generate a profit through it, that profit is passive income. Also, if you buy dividend stocks and get dividend payments, that income is passive income. It is called “passive income” because your asset or your money is working for you, allowing you to reap benefits without using your labor (which includes effort and time).

Let’s go through some examples:

 

Earned income:

Sam earns $100,000 annually as a Senior Manager in a Utilities company. While the position is prestigious and while Sam is thrilled to be working there, Sam is in fact earning “earned income” which is taxed at a much higher rate.

Because most of Sam’s family and friends are also in the working class, he doesn’t realize that there are more tax-efficient ways to make money.

Depending on where Sam is in the world, he would be paying as much as 40% tax on that income, resulting in a grand total of $60,000 annually.

At the end of every year, Sam always asks his wife “Honey, where did all our money go?”

A good chunk of Sam’s money went to the government, which uses it to build infrastructure, pay off debts, support healthcare, help the needy and also to fund wars.

And while many of these causes are commendable, Sam really does not have any control over how much he pays in taxes and where the money goes.

Sam continues to work at the Utilities company for the next 20 years and near the end of his career, is paid $150,000 per year, of which 46% goes in taxes, resulting in him pocketing only $81,000.

Needless to say, truly wealthy people do not make a lot of money from “earned income”.

Portfolio income:

Kylie is a married woman with a decent salary.

She is a senior secretary at a mainstream marketing company which employs 600 people worldwide.

She has a non-registered brokerage account in which she bought 1000 shares of Apple Inc. (AAPL) for $60 each for a total of $6,000 in 2013.

Because of the soaring popularity of Apple, in 2015 the shares were selling for $110 so Kylie sold them all for a total profit of $5,000 (11,000-6,000).

While Kylie was ecstatic with making $5,000, she doesn’t realize a couple of things:

  1. Her $5,000 profit will be taxed because she now has capital gains. She will pay anywhere between $1,000 to $2,000, depending on how much her reported income was.
  2. She sacrificed the asset (her shares) to make a profit
  3. She earned portfolio income which the truly wealthy seldom do.
  4. Her shares did not provide her with any income unless they were sold.

While sometimes selling an asset for a profit can make sense, financially intelligent people do not do this frequently.

 

Passive income:

Steve is a 33 year old software developer at a medium sized company in Los Angeles.

He is a financially astute guy.

He understands how money works.

He hates it when he has to park money and get no compensation in return and for that reason isn’t thrilled about playing the capital gains game.

Steve buys 1000 shares of dividend-paying Canadian Utilities (TSX:CU) in 2010 at $19 per share for a total of $19,000.

He chose CU because this company has had a record of paying higher dividends every single year for the last 42 years.

He was also able to buy the shares at a bargain price because stockholders of CU were unduly panicking and were selling their shares.

At that time, CU was paying out 4% in dividend yield so he made $760 ($19,000*0.04) the first year.

But since CU also increased its dividend every year by 5-6%, Steve was making more in dividends every subsequent year.

The best part is that Steve kept making passive income because he was getting paid to invest properly and he did not have to sell (read: sacrifice) the asset (the shares in this case) to make a profit.

Also, Steve pays almost 0% in taxes when he receives his dividend income because tax laws favor eligible dividend income.

This net income from dividend stocks is passive income because:

  1. Steve is using an asset to generate income (instead of his own labor)
  2. Steve is not sacrificing the asset to realize income

But that isn’t all.

Steve was also able to buy a duplex in a suburb close to Houston, when the housing market was crashing. Instead of paying the usual price of a standard duplex at $120,000, he was able to pay only $85,000.

He put a 20% down payment of $17,000 for the duplex and got the bank to loan him the rest of the amount.

As soon as the duplex was in his name, he rented it out to 2 small families.

Because he had financed 80% of the $85,000 purchase, he had taken a loan out of $68,000 at an interest rate of 3.49%.

Using mortgage calculators available for free online (https://tools.td.com/mortgage-payment-calculator/), he calculated his monthly mortgage payment to be around $339.15.

His monthly property taxes were $83.

The repair and maintenance for his duplex was $250 monthly.

Steve was able to rent out both units for $700 each, for a total of $1400.

 

His monthly profit from his duplex is therefore:

Rental revenue       $1,400

Mortgage payment  $339.15

Property taxes        $83

Maintenance           $250

Net income              $727.75

 

This net income from the rent of the duplex is passive income because:

  1. Steve is using an asset to generate income (instead of his own labor)
  2. Steve is not sacrificing the asset to realize income

 

In most cases, Steve will pay 2-5% tax on this income, allowing him to keep most of it for himself.

Also, because of inflation, he gets to increase the rents of his duplex by 2-3% annually, pocketing more income in coming years and still paying a very low tax.

Because of his financial acumen, he is able to retire at the age of 43 because his yearly dividend and rental income has increased over the last 10 years to $28,000.

And because he lives a modest lifestyle and since he has other sources of income as well (i.e. consulting part-time), he does not need to work for a living anymore, giving him decades to do whatever he wants, whenever he wants.

Needless to say, if you would like to be financially independent, it would benefit you to act like Steve.

If you read this email closely, you would have realized one central theme here.

People who are financially intelligent know that the only way to secure financial independence is to convert active income (salary, commissions etc.) to passive income (subscription based online income, dividend income, rental income, royalties).

Understanding the key differences between earned income, portfolio income and passive income is critical to your financial success.

Remember, all 3 of these income types are “earned” in a totally different manner and are taxed at different rates as well.

So here is Rule #5: Learn to convert active income into passive income as efficiently as possible.

I would suggest re-reading this email many times.

This is because while the concept is easy to understand, internalizing it can take a while.

Once again, you can only become financially independent by doing 2 things:

  1. Get your assets to work for you or
  2. Get your money to work for you

Steve is able to do both & he reaps the rewards of his creativity and financial acumen.

Thoughts? Suggestions? Feel free to leave your comments below.

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