Having a steady source of income can help you set financial goals and plan for the future. While the income of most people is comprised of salary, wages, and tips, there are several other types of income that you can consider. Understanding the different types of income can help you leverage your income and ensure you’re earning at your full potential. In this article, we discuss what income is, the different types of income, and factors that affect each type.
What is income?
Income is money that an individual or business receives in exchange for providing labor, producing a good or service or investing capital. People can earn income from wages, salaries, or tips and businesses can earn income by selling a product or providing a service. Income is typically earned regularly over time and has a set timeframe in which it will be earned. Most types of income are subject to taxation depending on the province in which the income is earned.
Why is it important to understand different types of income?
Understanding the different types of income can help you achieve your financial goals and remain financially responsible in your actions. Having a good understanding of your individual income can help you with budgeting, planning, and saving which is important to financial planning. Exploring different types of income can help you learn different ways to earn passive income and maximize your earning potential. Understanding the different types of income can also help you:
Use your hobbies and passions to make money
Save money for retirement
Invest in organizations you believe in
Support your family with extra income
Transition out of full-time work
Gain wealth steadily over time
Pay off student loan debt
Find small business partners
Start a small business of your own
Gain confidence in your financial future
What are the three types of income?
The three main types of income to consider are:
Active income
Active income refers to income received from a business or job that you actively participated in. This can be from performing a service, or selling a product directly from a business. Active income can come from wages, salaries, tips, bonuses, commissions, and net earnings if you are self-employed. For example, a Server at a restaurant can consider their weekly pay check as active income as well as any tips they receive during the time they are employed at that restaurant.
Active income does not include investment earnings including capital gains, property earnings, and foreign business earnings as these are subject to different taxation laws in Canada. In general, active income only encompasses income that is generated regularly over a specified time period that can be directly linked to work performed. Income that generates itself with minimal effort is not considered active income. Here are a few examples of active income:
Customer service work
Writing and editing
Management
Advertising
Sales
Software development
Web design
Marketing
Graphic design
Janitorial work
Teaching
Construction work
Passive income
Passive income is money earned from a rental property, limited partnership or other business in which you're not actively involved. For example, if you invest in a business without participating in its development, you'd be considered a silent investor receiving passive income. Passive income streams typically require an upfront investment and time to grow and maintain profit. However, investments like these can provide you with a regular stream of income in the future with little to no effort on your part.
Rental income is one of the most common forms of passive income as it requires minimal active effort to generate earnings. Aside from the initial investment and monthly maintenance expenses, property owners are able to earn income without actively having to put time into their property. With rental income, it’s possible for taxpayers to deduct most expenses at the end of the year, making this a lucrative form of passive income. Both investment and rental income is taxable in Canada and it’s important to report all forms of income when preparing your tax statement. Here are a few more examples of passive income:
Receiving loyalties from online book sales
Renting or leasing equipment
Renting properties
Participating in affiliate marketing
Selling independent merchandise from a blog or website
Becoming part owner of a business
Buying a blog or website
Portfolio Income
Financial investments are one of the most common forms of portfolio income. This can include low-yield investments such as savings accounts and investment certificates or higher yield investments such as dividends or shares of a corporation. Both types of investments allow the investors to earn a proportion of their investment back on top of the value they have invested. Since the amount is greater than the initial amount invested, it can be classified as income. Here are a few more examples:
Becoming a shareholder in a company
Opening a savings account to earn interest over time
Investing in book or music royalties
Buying limited amounts of stock in many different corporations
Investing in peer-to-peer loans (P2P)
Purchasing dividend exchange-traded funds (ETFs)
How do taxes affect the 3 types of income?
In Canada, most forms of income are taxable at a rate that reflects your gross income for the financial year. The rate at which you are taxed can depend on the province you live in, where your income comes from, and which incentives and tax-breaks you are eligible for. Understanding how different types of income are taxed can help you better prepare for the end of the fiscal year and can help you anticipate the amount in which you’ll be taxed before it happens. Here are some factors to consider when it comes to paying taxes on the different types of income:
Active income:
Income tax makes up the largest proponent of the Federal budget each year. The taxes you pay on your active income are used to fund government institutions and public services across Canada. Depending on where you live, the taxes you pay on you income will be divided amongst Federal and Provincial governments to be used towards public goods and services. Taxes on active income in Canada are progressive meaning the more you make, the greater the amount of tax you will owe.
Passive income
Depending on the source of your passive income, it can be subject to different types of taxation. Property tax is tax on an asset and reflective of the value of your propriety. The amount of property tax is dependant on the area of your property and helps fund various public services such as snow and garbage removal, road repairs, policing, and fire protection. Other forms of passive income such as limited partnerships or businesses are taxed at the same rate as small businesses. The first $500,000 of income earned is taxed at a lower taxation rate designed to support small businesses.
Portfolio income
In Canada, 50% of the value of your realized capital gains are taxable. For example, in the event you sell your investments for a higher rate than which you paid for them, 50% of the profit you make is taxable as capital gains. Unrealized gains are not taxed and these occur when the value of your investment increases but you don’t sell it in the financial year. For example, if your investment increases by $1000 during the financial year, you don’t pay taxes on 50% of the $1000 unless you sell the investment.
Tips for tracking your income
When earning different types if income, it can be difficult to track the source and amount each month to compile for tax season. This can make filing a tax return and predicting your tax amount difficult to do. It’s important to keep detailed reports of all income statements in the event you are audited. Here are some tips for staying organized with multiple sources of income:
Keep records of everything
In the event you are audited, the Canadian Revenue Agency will request evidence of all income you have claimed on your tax return. Having access to your income records can make this process easier to complete. Create a folder where you can keep all records of your income in the event you are asked to provide them.
Conduct monthly reconciliations
If you are collecting passive or portfolio income, the amount you receive each month can vary. Conducting monthly reconciliations to ensure all income has been recorded and collected can help you stay organized and account for any missing income. This can also help prepare you for filing your tax return as errors can be caught early.
Prepare your tax return early
The earlier you submit your tax return, the sooner you’ll receive any tax rebates you are owned. Preparing and filing your taxes early on can help you get paid sooner, and can give you time to make changes and revisions. By staying organized throughout the year, you can prepare your tax return faster and with fewer errors.