When it comes to personal finance, one of the biggest conversations has always been about active vs passive income. Knowing about their differences and how to use them in your life will help you succeed with money and create a more stable financial situation. Keep reading to learn more!
What’s the difference between active and passive income? Which one offers more benefits? What are each’s pros and cons?
And most importantly, how can you generate either or both?
I will answer these questions and give you a comprehensive guide on using passive income vs active income so you can start challenging yourself to reach your financial goals!
What is active income?
Active (or earned) income is what we earn from working. It could come from our jobs, businesses, or side hustles. This type of income requires ongoing effort to maintain and grow.
Active income examples
Active income can come in many forms, but all of them require, as the IRS phrases it, material participation in the income-producing activity. This essentially means, you’ve actively participated in generating this income.
Examples of active income sources include:
Job income
Earned through employment, such as a regular paycheck from a full-time job, tips for service jobs, or commissions for sales positions.
Business profits
Earned through business activities, such as selling products or services, the owner actively manages and makes decisions for the business.
Freelance income
Earned by providing freelance client services on a project-by-project basis rather than as an employee.
Consulting income
Earned by providing expert advice and guidance to clients on a specific topic or industry.
There are other sources of earned income, but those are four of the most common.
Advantages of active income
The primary benefit of active income vs passive income is that it provides a regular stream of income that individuals can rely on.
Whether we work a job, run a business, freelancing, or consult, we can generally count on receiving a consistent paycheck or payment for our work.
Disadvantages of active income
The most significant disadvantage is that it requires time and energy.
You must actively work and put effort into your job or business to earn income. It can be time-consuming and limit your ability to pursue other interests or hobbies. And you only have so many hours in the day to earn money this way.
Additionally, your income may be interrupted if you become sick or cannot work.
How is active income taxed?
When you earn an income this way, it will usually be subject to federal, state, and local income taxes, and also Social Security and Medicare taxes.
The amount you owe the IRS each year will depend on several factors, including your income level, filing status, and any deductions or credits you’re eligible for.
What is passive income?
Passive income refers to earnings generated without ongoing active involvement or effort. Usually, this income requires an initial investment or some hard work to set up—but once that foundation has been established, it continues to generate income largely on its own.
Passive income examples
Passive income can take many forms, but here are a few of the most common passive income sources:
Capital gains
Profits that result from the sale of an asset, such as stocks, real estate, or other investments. It is the difference between the purchase price and the selling price of the asset.
Stock dividends
Payments made to shareholders by a company from its profits are called stock dividends. They are typically paid out in cash or stock and paid quarterly or annually.
Interest
Earned from lending or having money in an interest-bearing account, such as your savings account or a CD, or from peer-to-peer lending.
Royalties
Payments made to a patent, trademark, or copyright owner for the right to use that intellectual property.
Rental income
Earned from renting out a property, such as a house, apartment, or commercial space.
For more details, explore our list of 30+ specific best passive income ideas.
Advantages of passive income
One of the primary benefits of passive income is the ability to earn money while you sleep. If you also have a full-time job, your passive income sources can make extra money while you work, which can turbo-charge your financial journey.
Passive income may provide a stable source of income without requiring continuous effort or work.
In my opinion, this benefits those who want to supplement their earned income streams or retire early.
Another advantage of passive income is that it can be location-independent in many cases. Once you’ve set up the income sources, they’ll continue running automatically no matter where you are, so you can earn passive income from anywhere in the world.
Disadvantages of passive income
One of the biggest drawbacks is that passive income can be less reliable than earned income.
Some passive income streams can fluctuate or disappear altogether, making it difficult to rely on them as a steady source of income, so you may need to create multiple sources of income.
Additionally, passive income often requires an initial investment of time or money upfront.
For example, starting a rental property business requires a significant cash investment to purchase, make necessary repairs, and market it to potential renters. You may also have to hire landlords or property managers if you don’t want to handle those responsibilities yourself.
Tax implications of passive income
While earning passive income can be a great way to build wealth and achieve financial freedom, it’s important to understand how it’s taxed.
In most cases, passive income is subject to federal income tax and state income tax in the state where the income is earned.
However, the tax rate for passive income may differ from what you pay on earned income, depending on the type of passive income and how it’s earned.
For instance, capital gains from investments will be taxed differently based on whether they’re short-term or long-term capital gains (basically, whether you held them for less than a year or not).
Qualified dividends are taxed at a lower rate than ordinary income, but non-qualified dividends are taxed at the same rate as normal income.
Most interest income is subject to ordinary income tax rates. However, certain types of interest income, such as municipal bond interest, might be exempt from federal income tax.
If you have specific questions about how the Internal Revenue Service taxes active vs passive income sources, it’s best to consult with a qualified professional.
The differences between active and passive income streams
With a basic understanding of each type of income under your belt, we can now look at the differences between active and passive income. It can help you determine which types of active vs passive income might be best for your lifestyle and goals.
1. Earning potential & scalability of active income vs passive income
The first factor you will want to consider is the difference in earning potential and scalability between active income vs passive income sources.
Active income is limited by hours and education
Your earning potential from earned income is limited by the amount of work you put in.
For example, working full-time has a cap on earning potential based on hours worked and your hourly wage or annual salary.
Creating professional goals and working on educational advancement can increase your earning potential, but these require more time and effort. Additional education or training can lead to higher-paying jobs but require significant investment and may impact your work-life balance.
Passive income has fewer limitations after the income source is set up
This sort of income stream generates revenue without ongoing active participation, which makes it attractive.
For example, rental properties generate income each month when tenants pay rent. Successful blogs and online courses can generate income through advertising, affiliate marketing, and sponsored content.
Scaling is possible by expanding the source of income, creating additional streams, or purchasing a new income-producing asset.
Although a significant upfront investment in time and/or money is required, passive income sources may provide reliable and consistent income for long-term wealth once they’ve been established.
2. Investments of time and money for active vs passive income
Next, something I would consider is how much time and cash you’ll need to initiate and sustain active vs passive income.
Active income only makes money with constant effort and time
Earned income needs consistent time and effort for revenue, meaning stopping work stops income. It requires steady work to ensure regular income, involving a significant investment of time, energy, and ongoing education to maintain earning potential.
Pursuing higher education or training courses can be costly but lead to higher salaries and better job prospects.
In addition, ongoing development and training help you maintain earning potential and stay ahead of industry trends.
This income usually has minimal initial financial investment if you’re getting a traditional job or starting a side hustle. But starting a business or higher education may require steep upfront costs, such as equipment, marketing, tuition fees, or loans.
However, these investments can pay off in the long run by increasing earning potential and career advancement opportunities.
Passive income requires time and effort but not consistently
My thought is you’ll almost always have to make some kind of initial investment to start earning passive income, but some methods require less capital than others.
For example, if I purchase real estate investments, it requires more work upfront than becoming a stock investor.
Further, passive income requires significant time and effort to set up, including research, planning, and creating a product or service.
However, once established, it provides steady income with little ongoing effort.
Passive income can offer greater freedom and flexibility than traditional income streams.
With passive income, individuals can generate revenue even when not actively working. It can allow for a more flexible schedule and the ability to pursue other passions or interests.
3. Risks of passive income vs active income
Finally, research the risks of active vs passive income before going all-in with an opportunity. There is a large difference between active and passive income regarding risk.
Active income has risks like loss of larger income or potential failure
Earning active income may seem less risky, but it still has inherent risks.
For example, the fixed salary or wage in a contract means few opportunities for additional revenue, making it difficult to increase earnings even with more time and effort.
Plus, entrepreneurship or starting a business with no money involves significant risks. It requires a substantial investment of time, effort, and money, and the risk of failure is always present.
In addition, unexpected factors, such as changes in the market, can impact your career success despite careful planning and research.
Active income streams can also lead to burnout and career stagnation. The demands of a job can cause a lack of work-life balance and affect mental and physical health.
Without growth opportunities, employees may feel unfulfilled, decreasing motivation and earning potential.
Passive income has risks that may be beyond your control
Passive income streams require an upfront investment, which can be risky if returns are unstable.
For instance, investing in rental properties or stocks may be profitable, but the market is unpredictable. There’s a risk that the value of something you bought as an income-producing asset (like a rental property or dividend stock fund) will decline instead of increasing.
Further, some passive income sources require a certain degree of maintenance, which may result in revenue loss if not properly handled.
For example, rental properties require tenant management and upkeep, while investment portfolios may require monitoring and adjustment.
Expert tip: Diversify your income sources
Passive vs active income doesn’t need to be an either/or situation: I think there’s room for both in your overall financial plan! And the more income sources we all have, the less vulnerable we’ll be to any risks.
For example, if you lose your full-time job, but you have a side gig and income-producing assets, you’ll be in a better position to afford your bills while you hunt for a new opportunity.
On the other hand, if you only have one source of income, you’ll be completely reliant on that source. If it disappears, you’ll have to scrape by and deplete your savings as you live without a job.
How to use both types of income in your life
Most people’s ultimate purpose for their money is to grow it throughout their lifetime, using it to fund their various financial goals and retirement.
The good news is that both types of income can work together to help you grow your money and continue generating more! You can:
- Use active income to generate passive income
- Use active income to generate more active income
- Use passive income to generate active income
- Use passive income to generate more passive income
No matter what approach you take, these strategies are great ways to increase your wealth. Let’s look at how they work.
Using active income to generate passive income
While earning an active income is important for paying the bills and supporting your lifestyle, you can also use that money to build long-term wealth and financial freedom by investing your earned income in assets that generate passive income.
Simply funnel a percentage of your active income toward your passive income. This could be anything from saving up a down payment for a rental property to purchasing dividend-paying stocks or investing in index funds and bonds.
Another way to create passive income is by starting a business or side hustle. For instance, starting an online store or blog, or writing an e-book.
Using active income to generate more active income
You can use your existing income to create more active income!
A good way to do this is by investing in yourself and your career. This could mean taking on additional work or side hustles to increase your income or investing in education and professional development programs that can help you earn more money in your current job or industry.
Using passive income to generate active income
Did you know you can also use passive income to create active income streams?
One way to do this is by reinvesting your passive income into opportunities that generate earned income. For example, something like starting a new business or launching a new product or service would make sense.
Using passive income to generate more passive income
With a little bit of smart investing and dedication, you can use your passive income to create a powerful snowball effect of passive income that grows over time and supports your financial goals.
One way to do this is by reinvesting your passive income into more passive-income-generating assets.
Another way to use your existing passive income to support your financial journey is by using it to get out of debt or reduce expenses. By paying off high-interest debt or decreasing your monthly bills, you can free up more money to invest or save for retirement.
Is rental income active or passive?
Rental income is typically considered passive income. Because once the property is set up and rented out, it will generate income with minimal ongoing effort.
However, if you don’t have a property manager, you’ll have to manage it yourself and be responsible for the tasks that landlords handle, so there is still some active participation involved. These tasks might include maintenance and finding tenants.
Ultimately, if you can afford to outsource the labor, which I recommend, you can make it as active or passive as you decide.
Is it better to have passive income vs active income?
Ideally, you should have a mix of both, especially during your career years. But it’s particularly important to constantly build up your investment portfolios and other passive income sources.
That way, you can eventually quit your full-time job, retire, and live solely on your portfolio income and other income producing assets. The question of whether to make passive income vs active income isn’t an “either/or” answer but a “both!”
What are the differences between passive income and earned income?
Earned income is money you have to make using your time and effort consistently, and passive income requires less ongoing effort.
Earned income is the same as active income, which is money you receive in exchange for your labor (through a job, side gig, etc.). It’s very common, and many people rely on it.
Passive income comes from sources that don’t require much ongoing effort. Instead of you making the money, your income-producing asset or investment makes the money for you.
Articles related to various income types
After learning about the various ways to earn money, you might want to know more. Check out these articles next!
Active vs passive income: leverage both to achieve your financial goals!
The difference between active and passive income is that they present two very different routes for making money.
But both can be incredibly lucrative depending on your preferences, goals, and financial capabilities. For some people, a mix of passive and earned income may be ideal. Others may prefer to put all their effort into generating passive income streams.
Understanding the differences can help individuals make more informed decisions about their income strategies. And creating various income streams can increase financial stability and independence.
Read the full article here
