CFO of Life #86: The Income Illusion: Why Understanding Your Money Matters More Than You Think

Saving and investing are of significant importance for your finances, but the only thing that is more important is understanding your income.

And unfortunately people spend more time trying to make a 100% return on their $1,000 investments than on making that through their income.

I wouldn't complain if I could take $500 and make it into $300 extra or more a month, but focusing your willpower on growing your income could do that. In this example, the $500 represents a certificate that you can take which can easily bump your salary by $2,000 or more. And I know many people who’ve done that, including me.

That is only one example of why understanding your income and how it works is extremely important and the greater impact it can have. This is exactly what this week's article will do.

I know that quite a few of you know what income is, how it works and what impacts it, but before we get into the more complex topics, it is worth setting a solid foundation. Here we go!

1) What is income?

Income is the money you regularly receive from work, investments or benefits.

Or simply said, all money that you have earned one way or another. That being said, don't confuse refunds with income. A refund is money you get back from a purchase that simply didn't work out.

Also, most of the time, I would refer to income as the money that you get in your bank account after you pay all your taxes. I prefer using this number, as it is completely controlled by you and your spending. Because you can't control how much tax you pay, but you can control how many avocado toasts you have in a week and how many coffees you buy.

And in those rare cases when I refer to your salary, that would mean your income before tax. You can negotiate with your employer, but it is not guaranteed that you will get the salary you asked for. That is why, I want to separate the two types of income, as the degree of control you have towards your salary is a lot lower than your net income. But soon we will dive deeper into this, I promise!

2) The most common types of income

When I say common, I mean that most people would have earned most from those in their lives. Now, this is not aiming to be an exhaustive list, it is more of a representation that will get your thinking juices flowing!?

Earned income: Any money you make from salary, commissions, tips, bonuses or any self-employed work. Think about it as the money you make in exchange for your time!

Capital gains income is the profit made from selling assets like stocks, real estate or investments. Simply said, this is the profit you make on your investments or the money your money made for you.

Tax-exempt income is income that you make that is not taxed by the government. This can be benefits, grants, scholarships or any non-taxable income.

On a high level, it is that simple, but it could become a lot more complicated if we look into it.

3) What is the difference between active and passive income

The next thing we need to look into is active vs passive income. It is important to understand that many people talk about money, but they rarely take a moment to look into the details.

To start, active income is the one you get from work that requires you to put time and thinking into it. This is also earned income and here are a few different ways to earn it that come into this category:

Wages or the money you are paid from hourly jobs, manual or usually service-oriented blue-collar jobs.

Salary or the monthly payment you get from your full-time job. It is usually the same amount and it comes at the same time of the month.?

Bonus is the additional payment you receive from your employer as a reward for great performance.

A tip is usually an amount of money you get in addition to the payment for your service and is something customers leave in most service jobs. Commission is your payment for any direct or indirect sales that you have made.

Another common active income is a side hustle of any kind. It is usually any freelance work you do, any online business you have or you selling those handmade goods you make.

On the other hand, passive income is something you earn with no or with minimum effort. Most of those passive incomes only require some initial work to set up and then they are all good to go for a long time! And that is why people are excited for:

-Rental income from any property that you own but rent to someone else to live in or use as an office or a storage unit.

-Interest income from the interest you earn on your savings, bonds or loans you have given to other people.

-Dividends are the payments you receive from companies that you are a shareholder in.

-Royalties are ongoing payments for the use of patents, books, music or any creative work that you have provided for other people to license in exchange for money.

All that is mostly income that you worked for, even if it was a little bit, but there is income that we can classify as “unearned" that still comes under the passive income umbrella. Here are 3 good examples of what goes here:

-Government benefits as any financial assistance you get from the government. This captures any welfare, unexpected benefits, grants, scholarships or even free travel.

-Gifts and inheritance is a type of income that you receive from other people, as they want to help you with some money towards your goal or your rich uncle wanting to set you up for life!

-Benefits from your employer are a great example of "unearned income” that can help you a lot. It is all those things that your company gives you as a "bonus” that are available to everyone. And this topic is so underrated so I will do a deep dive in the next few weeks.

4) What are the things that impact your income and why should you care?

As we already established, you have some influence over your salary, but you have 100% control over your income. That is why, it is important to understand what influences the amount you take home and how you can impact it to improve your earnings.

Now, the most obvious thing is tax. This is the biggest drawback for your earnings. In some cases, it could go up to 45%-50%. And you can't do anything to get it changed, this is why you need to care how much you get taxed and actually, explore if you can lower that. There are two ways that you get taxed on your income, it is either a flat tax or a progressive tax.?

A country that has a flat tax would take a fixed amount of tax regardless of your income. So if you make $100k on a 20% tax rate you will pay $20k and even if you make $100m on the same tax rate, you will still pay $20m.

At the same time, a progressive tax rate will continuously increase with the increase in your income. For example, in the UK, the more you earn the more they will tax you. Your first ￡12,5k is tax-free, but then progressively you pay 20%, then 40% and then 45%. So, the more you earn, the more you will pay in tax and the less you will have to spend. Luckily, those tax levels only apply to your earned income but not to passive or investment income. They usually are taxed at a significantly lower tax rate. For example, for every extra ￡1 I make from my job, I pay ￡0.4 to the government. At the same time, I pay 20% on all the investments that I make outside my tax-advantaged investment accounts.

This is the second best thing that you can do with your money to reduce your tax and increase your income (not financial advice!). In some countries like the UK, you can benefit from contributing a % of your income towards a second pension and the government gives you a tax break, which is great, and on top of that, you can get additional contributions from your employer. So if you contribute 5% of your salary and your employer contributes another 5%, that makes it a total of 10% tax-free investments into your pension.

And that will grow from your first day of working to the last paycheck, and it would be your supplemental pension account. It will make your retirement journey a lot smoother and easier, but you should not completely rely on this!

Education & Experience are the two biggest determinants and multipliers of your income. The more education you get, the higher (on paper) your salary will be. And the more experience you gain, the more that will multiply your salary. For example, quite a few entry jobs require a 3-year degree and no experience will get you between ￡30k and ￡50k in London. But 3 years of experience and the same degree will get you ￡40k to ￡80k, just because you have learned more and you are a more productive employee. Now I hope that this is painting the picture of how important it is to understand the impact of experience and education on your future income.

Debt is the easiest-to-control component of your income. It continuously takes away the money you have, but hopefully, you’ve used it as leverage to buy something worthwhile. However, if you didn’t and just wanted to keep up with the Joneses and now you have a Credit card bill that grows by 20%, you know you are in a not-ideal situation, but you can get out of it.

As you can see, income is a huge topic with a lot of twists and turns and plenty of things you can do to increase it. But to summarise, you should understand how much you make per month before and after tax, how much you can contribute towards your pension and how you can shift from making earned income towards invested income. All those take time to learn and understand, so don’t bruise and batter yourself if you haven’t realised it by now. It is a marathon, not a sprint! So let’s strap in, count this as the first step and run together!

Next week, we will look into one of the most underrated topics in personal finance and that is “Perks at work”. I have spoken about this in a few of my previous articles, but now it is time to do a deeper dive into this topic and how and why you should make full use of it!

Thank you for reading! All comments and topic suggestions are highly appreciated. Post #86 in the series CFO of Life #si #personalfinance #CFOofLife