Lesson 8: Types of Income Accounts
Debits & Credits for
Primary Income & Side Hustles
In personal finance, we all have less income accounts than expense accounts, because we normally receive income from a limited number of sources and spend on a variety of different things. Salary/Wages Account is often the most used Income account; it tracks paychecks and tips received from a job. In Lesson 7 Example 1, you collected a paycheck for $1,000 so we credited an income account. The income account would have been the Salary/Wages Account
There are four primary methods of receiving income, each affecting different asset accounts:
Cash --> Cash Account
Direct deposit, Check or Zelle --> Checking Account
Digital fin-tech --> Venmo, Cash App or Paypal account
Bitcoin/Cryptocurrency --> Crypto Account
Here is a quick summary of the possible debits and credits on the Balance Sheet, depending on the payment method, when you receive income from your job:
Some people have secondary sources of income; maybe a second job or a side hustle/small business. The possible debits and credits for secondary income will look just like Figure 8A, only with a different income account. Let's take a look at an example to see it in action:
Example 8-1: You have a job and side hustle selling something on Etsy. Today is payday for both, so your paycheck of $1,000 gets direct deposited into your Checking account and an Etsy payment of $200 gets deposited to the same account:
Left (Asset) Side: Since your Checking Account increased twice, two debit entries totaling $1,200 are entered into the account.
Right Side: Since these transactions cover two sources of income, two different income accounts are involved. Both credit entries increase equity (Net Worth) by $1,200.
Assets = Liabilities + Equity
$1,000 + $200 = $0 + $1,000 + $200
$1,200 = $1,200
Important Note 1: This example covers two transactions with the same Balance Sheet because the Balance Sheet is all encompassing. In reality, your Balance Sheet contains every active account at the moment. For educational purposes, I am only showing you the specific accounts affected based on the transactions described in each example.
Important Note 2: The account titled "Side Hustle" could have easily been called "Etsy shop" or "Etsy Biz" instead. The beauty of bookkeeping is that the text used across the system is at the discretion of the bookkeeper. The numbers are the numbers but the text can be whatever makes the most sense to the bookkeeper/accountant.
Unrealized Capital Gains
For the most part, a primary and secondary income account is all that most of us need in our personal finance accounting system to properly account for the cash we receive. However, unrealized capital gains are a huge part of your Net Worth so they must be properly accounted for as well.
Unrealized Capital Gains = increase to your equity when assets you own increase (appreciate) in value = an increase in equity as a result of owning assets instead of an inflow of cash
Unrealized = not settled to cash yet; the value is still based on the market value of the asset, not a cash value. The value is 100% real and yours, it simply has not been realized yet by selling.
Unrealized Capital Gains come from investments, like stocks, real estate, cryptocurrency, small business equity stake, etc. If you own assets with fluctuating market values (prices) then your Net Worth is constantly changing (daily in many cases) based on these unrealized gains. The following example shows you how:
Part 1: You transfer $100 from your Checking Account to your Brokerage (investment/stocks) Account. You then buy 1 share of Apple stock at $100 per share.
Important note 1: Like our examples in the previous lesson, this transfer between asset accounts does not change Net Worth.
Important note 2: Buying the actual share within your brokerage account is not a transaction covered by your books. Your Balance Sheet contains the overall value/balance of your brokerage account (total value of all your stocks) and all cash transferred in and out, but it does not track individual stock purchases and sales. You can, of course, maintain a separate spreadsheet that tracks all of your stock transactions, but it is not necessary since your broker will send you monthly statements. As you can see, bookkeeping is all about organization and rules, even down to knowing what should and should not be included in our books.
Part 2: Six months later, the price per share grows to $120:
Left (Asset) Side: The stock that used to be worth $100 is now worth $120. Therefore, the asset value on your Balance Sheet increases by the same amount. The account was already standing at $100 from part 1 of the example, so a debit of $20 is needed to increase it to the current value of $120.
Right Side: Since your total Asset value is now $20 higher, your Net Worth is also $20 higher. Which means an Equity account must be increased (credited) too.
Assets = Liabilities + Equity
$20 = $0 + $20
$20 = $20
Important Note 1: Although you have not yet sold the share and did not receive an extra $20 in your Checking Account (or any other spendable way), your Net Worth still increased as a result of you owning the share. To truly maximize your Net Worth, you have to understand the power of appreciating assets and change your mindset towards financial risk. The Assets category of your Balance Sheet does not refer to solely spendable money; it refers to a variety of valuable things!
Important Note 2: Remember, accounts are balance trackers. Your Brokerage/Stocks Account would contain both debit entries (six months apart) for a balance/value of $120, as shown in Figure 8E:
Bonus Note: For tax purposes, the IRS only cares about realized capital gains when it comes to investments. Realized gains are gains from selling assets. Realized basically means real, actual or final. You only owe taxes when you sell investments, not for simply owning them.
As briefly mentioned above, investments like stocks, real estate, cryptocurrency, and small business equity stakes are the primary investment related asset accounts on a personal finance Balance Sheet. The figure below shows the possible debit and credit combinations on the Balance Sheet for unrealized capital gains on different types of Assets. Each type of transaction follows similar mechanics as Example 8-2 above.
A Brokerage Account (as described in the example above) is an account that allows you to buy, hold and sell stocks, options, ETFs, bonds, and mutual funds. You can transfer money between your Brokerage Account and your Checking or Savings account then buy whatever investment security you would like! I suggest everybody open a Brokerage Account and regularly deposit money into it to buy stocks and ETFs.
401k is the typical type of retirement account we have all heard about. One that the company you work for opens for you and deposits pre-set amounts into predetermined investments on your behalf. This gives you an easy method of automatic investing + reduces your taxable income + many companies offer a match. The value/balance of your 401k is an asset on your Balance Sheet that you own and unrealized capital gains are recorded as income as the asset values increases. You can not withdraw the money until you are 59.5 or you will incur harsh fees. It is a retirement account so it is legally structured to prevent you from before assumed retirement years.
IRA stands for individual retirement account, meaning it is a retirement account you open and maintain on your own. Basically all retirement accounts are just ways to invest in the stock market. Unlike a 401k but similar to a Brokerage Account, you have to deposit the money into an IRA on your own. Just like a 401k and the other investment accounts, an IRA is an asset on your Balance Sheet that you own and unrealized capital gains are reported as income as the asset values increases. IRA's have the same 59.5 year old minimum as 401ks.
Property/Home Value: When you purchase a home, the value (price paid) gets added as an asset to your Balance Sheet (don't get too excited; the mortgage gets added a liability). As renovations are made or general real estate appreciation occurs, the value of your home increases. These unrealized capital gains increase the Property/Home Value account on your Balance Sheet and simultaneously increases your Net Worth. Home flippers and real estate investors maximize their Net Worth by taking advantage of the huge/quick boost in Equity that homes can offer. Homeowners benefit as well (covered in detail in a later lesson)!
Bitcoin/cryptocurrency: When it comes to your Balance Sheet, crypto performs just like stocks. Similar to transferring money into an account held with a broker company, you transfer money into an account held with a crypto exchange company. You then buy crypto and hold it in the wallet provided by the exchange company (or a different type of private wallet of your choosing). The total value of your crypto wallets are reported as an asset on your Balance Sheet and unrealized capital gains are reported as income as the asset values increase.
Income and assets are the fun parts of finances. They drive us and they drive our Net Worth. The examples in this lesson should show you the power of both increasing income and buying appreciating assets: More income = higher asset and equity accounts = more discretionary income to buy appreciating assets = more income = higher asset and equity accounts = more discretionary income to buy appreciating assets = more income...
Click here to continue to the next lesson covering the less fun side of finances... expenses.