There’s an old parable that goes something like this: If you’re poor, you must work for money. But if you’re rich, money works for you. This paints a picture of the difference between active and passive income. Let’s explain the differences and why, if you’re smart, you’ll work to earn both kinds.
Key takeaways
- Passive income requires minimal ongoing effort after initial investment or creation and includes rental income, dividends, interest from savings or CDs, while active income entails direct work involvement such as salaries or commissions.
- Passive income offers financial freedom, flexibility, and location independence, acting as a safety net and potentially allowing for early retirement; whereas active income is limited by time and depends on one’s physical ability to work.
- Diversifying income through a mix of passive and active streams can enhance financial resilience and stability, and understanding the differing tax implications can optimize overall financial strategies.
What is the difference between passive and active income?
Passive income is money one earns that requires little ongoing personal effort. Active income is money earned through work.
Examples of passive income include rental income from a property, dividends from stocks, or royalties from a book. The key is that these sources generate income with little-to-no daily effort on your part.
On the other hand, active income, also known as earned income or ordinary income, is the money earned through direct involvement in work or services, such as salaries received from jobs or earnings from self-employment. It involves trading time for money, and its generation is directly tied to your ongoing efforts and labor. In contrast, unearned income is generated without direct involvement in work or services.
Examples of passive income
A common example of passive income is the interest accrued from a high-yield savings account and certificates of deposit (CDs). These financial products provide a return on your investment in the form of interest income. The beauty of this type of passive income is that your money is working for you, without you lifting a finger.
Another passive income stream is dividends from stocks, particularly from well-established “blue chip” companies like Procter & Gamble, Johnson & Johnson, and McDonald’s. By owning these stocks, investors can receive a regular source of income generated from the company’s profits.
Examples of earned income
Most people are familiar with active income, as it’s the most common way people earn money. Earned income includes wages and salaries, with salaries being fixed amounts paid by employers and wages being hourly earnings.
Commissions and bonuses are another type of active income. Professionals like real estate agents and sales personnel often receive these as compensation based on sales or service achievements. These forms of active income reflect the direct impact of personal effort on earnings.
Advantages of passive income
Financial freedom is a major advantage of passive income. With passive income, you can pursue personal interests without the pressure of a traditional job. This financial freedom can lead to earlier financial independence and even retirement.
Passive income also allows for flexibility and freedom of location. You’re not tied to a physical location or set working hours, which means you can earn money from anywhere in the world. It also acts as a financial safety net, maintaining cash flow even without active work.
Challenges of active income
While active income is a reliable and straightforward way to earn money, it has limitations. Your earning potential from active income is directly proportional to the time and effort invested. This places a ceiling on your earning potential, as there are only so many hours in a day.
Additionally, active income relies on your physical ability to work. Should health issues arise, it could potentially lead to a loss of income. Enhancing active income often requires additional education or the development of new skills, posing both challenges and additional expenses.
Tax implications of passive and active income
Grasping the tax implications, including income tax, associated with your income streams is vital. Typically, active income is taxed at higher rates than passive income. However, it’s important to be aware of tax exempt income as well. Some examples of active income include:
- Wages
- Salaries
- Commissions
- Tips
These forms of active income are subject to payroll taxes, which include both Social Security and Medicare taxes in the United States, as well as federal income tax and other federal taxes. Additionally, understanding these tax implications can help individuals navigate government benefits.
However, when combining active and passive income sources, including net investment income, there can be potential tax advantages, such as the ability to offset capital gains with losses or employing tax-advantaged investment strategies to minimize net investment income tax.
The importance of diversified income streams
A diverse income portfolio is as indispensable as diversification in investing. By combining active and portfolio income, such as passive income, you reduce risk, increase resilience, and provide financial stability.
For instance, adding index funds or fixed-income funds to your investment portfolio provides long-term diversification and protection against market volatility. Also, buying a local business can provide passive income if managed by someone else, making it a strategy for diversifying your income portfolio.
Strategies to generate passive income
There are a number of ways to generate passive income, but creating any passive income stream will require either capital (cash on hand), up-front work, or both.
Examples of passive income you can earn by investing capital include:
- Interest on a savings account, CD, or savings bond
- Dividends from stocks or bonds
- Investing in Real Estate Investment Trusts (REITs)
- Collecting rent from a directly-owned investment property
Examples of passive income you can earn by putting in up-front work include:
- Royalties from publishing a book or song
- Ad or affiliate income from publishing websites or video content
- Sales of an online product
Balancing passive and active income
To achieve financial goals, adapt lifestyles, and optimize tax strategies, it’s imperative to strike a balance between active and passive income. Achieving financial goals and flexibility is more attainable with a balanced approach to these income types.
Passive income has the potential to replace a full-time job but usually requires a substantial amount of time and effort in building the necessary assets.
Leveraging tech for passive income generation
The digital age brings along innovative technological and online platforms for generating passive income. Creating a blog or YouTube channel, for instance, can generate passive income through advertisements, sponsorships, and affiliate marketing once a significant audience is built.
A robust social media following can also be monetized through sponsored posts, turning a social media presence into a source of passive income.
Common misconceptions about passive income
Even with its benefits, passive income is often misunderstood. One is the idea that passive income requires no effort or investment. While it’s true that passive income is designed to require less ongoing work, it does require an initial investment of time, money, or both.
Another misconception is that passive income does not require ongoing maintenance or oversight. In reality, most passive income streams require some level of ongoing maintenance to ensure they continue to generate revenue.
Summary
Understanding the difference between active and passive income and how to leverage each can significantly impact your financial freedom and lifestyle. While active income provides a steady income source, passive income offers the opportunity for financial freedom, flexibility, and early retirement. Both have their place in a diverse income portfolio, and the key is to balance them according to your financial goals and lifestyle preferences.
Frequently asked questions
What is difference between active and passive income?
Active income requires you to work for it, like through a job or providing services, while passive income comes from assets you own, like stocks or rental properties. It’s important to earn active income first to invest in passive income assets.
Is it better to have passive or active income?
Diversifying your income streams with both active and passive sources can provide a more stable financial foundation. By understanding and leveraging the benefits of both, individuals can achieve their financial goals and create a more adaptable lifestyle.
Is rental income active or passive?
Rental income is considered passive by the IRS, as it is generally earned from tenants’ use of the property. Therefore, it is not classified as an active income.
What is legally considered passive income?
Legally, passive income includes earnings from rental properties, book royalties, and other sources where work has already been done to generate the income. The IRS defines passive income as earnings from sources other than employment or active participation in a business.
What is passive income?
Passive income is money earned without having to put in daily effort, allowing for financial stability and freedom.
Final Thoughts
Passive income can be a great way to earn more while working a regular 9 to 5, or it could fully replace your current stream(s) of active income entirely.
When it comes to building real wealth, however, the discussion around active vs. passive income is more nuanced.
According to a five-year study of 233 wealthy individuals, a common thread between them was that self-made millionaires generated income from multiple sources. 65% of them had three streams of income, 45% had four streams of income, and 29% had five or more streams of income.
These figures suggest that when it comes to building wealth, it’s not just a question of prioritizing passive vs. active income. Rather, it’s about generating multiple streams of income and scaling your time.
Personally, I have four streams of income:
- The income I make from my 9 to 5
- Investment capital gains
- Dividends
- Freelancing work
You can leave it to your own creativity and aspirations to find what constellation of passive and active income streams works best for you. But remember, whether you are looking to create passive or active income, there is no free lunch, and any source of income that ultimately becomes passive will likely start as a highly active pursuit.
