Passive vs Active Income: The Complete Guide
October 10, 2022
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There are two types of income streams, passive vs. active income. They both earn you money, but in different ways. Most people start with active income but eventually convert to a combination of active and passive income or strictly passive income.
Here are the essential things to know about the different types of income.
Passive Income vs. Active Income
Understanding how passive and active income are different is important. Millionaires have several different types of income streams, combining active and passive income to grow their net worth, and you can do it too.
What Is Passive Income?
The passive income definition is simple. It's income that comes from income-generation assets. There are hundreds of options, but they have some similarities.
- Most passive income investments don't require your physical presence to continue to make money.
- All passive income investments require an upfront investment of your capital.
- Some passive income opportunities require some work up front, but then you earn the rest of the income in your sleep.
- Some passive income earnings have tax benefits to lower your tax liability.
Examples of Passive Income
There are many forms of passive income, but here are two simple examples of passive income.
You deposit $1,000 in a 6-month CD. The CD earns money, so it has a $1,100 value when it matures. The $100 is passive income because you didn't have to do anything for this earned income. Instead, you contributed the funds upfront and the interest income accrued.
You have a second house that you don't use year-round. Rather than letting it sit vacantly, you rent it to tenants throughout the year, earning income from a rental property. The income is passive because you don't have to work daily to achieve it.
Pros & Cons of Passive Income
- You can make money without actively working.
- Some forms of passive income have tax benefits.
- Most passive income streams aren't subject to Social Security tax.
- You can increase your earnings as high as you want beyond what you can physically manage.
- You need active income to create passive income (it takes money to create money).
- Many passive income streams pose a risk of loss, such as investing in the stock market or real estate agents.
Types of Passive Income Streams
There are many passive income opportunities, making it easy for people of all skill levels to start earning passive income. The best way to make passive income is the tasks you're most comfortable with, but here are some examples of passive income jobs.
Real estate investing is a great way to earn passive income. For example, you can earn a passive income stream by investing in rental property. You have many options when investing in real estate, including residential rental properties, commercial properties, crowdfunding, and real estate investment trusts.
Determine the level of responsibility you want to take and what risks you can handle. For example, you can own an investment property, manage it, and collect monthly rental income. You can also hire a rental property management company to handle the property if you don't want the hassle of being a landlord.
If owning real estate doesn't appeal to you, commercial real estate investing may be a better option. Crowdfunding and real estate investment trusts allow you to invest as little or as much capital as you want and invest in large real estate investments with other investors. You generate passive income through rent and capital gains.
Silent Business Partner/Owner
Another popular passive income example is becoming a silent partner. You own part of a business but don't have any management or business operations responsibilities. This works well for investors who have the capital to own a business but don't want the headache of managing it.
You still have a say in certain business matters but aren't in the business's daily tasks and responsibilities. To be a silent partner, you must sign a Limited Partnership Agreement.
Investing in Stock Markets
Dividend stocks are a great way to earn passive income. Investing in successful companies allows you to take part in the profits that companies pay out as stock dividends. You decide how to use the funds, whether reinvesting them for further earnings or withdrawing the funds.
This passive money-making opportunity allows you to earn income monthly or quarterly and invest long-term by holding onto the stock.
Precious metals have consistently had solid returns, creating a conservative and passive form of income. As a result, investors often choose to invest in precious metals, such as gold, versus depositing funds in savings accounts.
On average, gold has annual returns of 2.5 - 2.75%, and all you must do is contribute your funds to buy the asset and then sit back and enjoy the passive income stream.
Investing some of your capital in permanent life insurance, such as whole life insurance, can provide a passive income stream later in life. Whole life insurance has a death benefit, but it also has a cash value.
The death benefit is what your beneficiaries receive when you die, similar to a term life insurance policy. The cash value accumulates at a fixed interest rate, and you can withdraw the funds at any time, either as a loan or as passive income.
Digital Product, Online Course, or Community Development
Creating digital products is another popular passive income example. You can create a product once and sell it repeatedly, earning passive income. Examples of passive income ideas are online courses, stock photos, and community groups.
Keep in mind, though, some digital products need updating, so there may be some work involved, but overall, they are forms of passive income.
Affiliate income comes from links you post on your blogs, vlogs, or social media accounts. You can monetize your channel if you have a large blog audience online or a large social media following. You earn a commission each time a follower clicks on a link and buys something.
Display advertising is like affiliate income. You place ads on your blog, vlog, and social media platforms that your followers click on and buy something, and you earn a commission.
Remember, it can take months or even years to earn passive income from display advertising because you must first build an audience.
What Is Active Income?
Active income is money you earn when trading your time. For example, your full-time job is active income. This is because you actively go to work and earn a salary or hourly wage in exchange for your time. You can also earn active income from self-employment, part-time job, or side gig.
Examples of Active Income
When looking at active vs. passive income, earning an hourly wage is a good example. You get paid a set amount per hour that you work. However, you also control how much money you earn if you can work overtime or holiday hours and earn a higher wage.
Active income salary is another form of active income. You get a job with a set annual income. In return, you promise to work 40+ hours to earn the income.
Pros & Cons of Active Income
- You can work your way up the ladder and increase your income.
- You control how much you make by how much you work, such as starting a side gig or adding a part-time job.
- You know how much you'll earn in exchange for your time.
- You don't get paid if you aren't actively involved.
- You can only do as much as the hours in the day allow.
- Your income is taxable at your ordinary rates.
Active Income Ideas
The most common type of active income is the money earned from your salary or hourly wage at your full-time job. The difference between passive and active income is that you must work to earn money, like your full-time career.
You can make money consulting if you have skills you can use to consult others. This requires active work, but you can do it on the side, or it can be 100% of your active income. Consulting works well for people who excel at their skills and can help others on the side.
Freelance services are another way to earn active income. You can start side gigs that use your skills in your regular career or something different. Active income ideas for freelancing include web design, writing, proofreading, and data entry.
Equity compensation is a bonus earned by high-level executives and employees in certain positions. You must work to earn equity compensation options, which may include stock market shares or stock options.
Bonuses and Commissions
Bonuses and commissions aren't fixed income sources but active income. You earn them in addition to your salary. For example, you may earn commissions when you sell products and bonuses when the company or your department reaches a particular milestone.
You earn capital gains when you buy an asset low and sell it high. The difference is your capital gains. You earned it by investing in an asset, monitoring it, and selling it at the right time. Then, depending on the timeline you kept the investment, you might get tax breaks for long-term capital gains.
Flipping property provides a different type of income. To flip property, you buy an undervalued property, fix it up, and sell it for more than you paid to purchase and renovate it.
This income stream isn't passive because you must actively renovate the property and market it to sell. So you're constantly involved in the process until you transfer the property.
Old Goods and Furniture Flipping
If flipping property is too much, another way to earn money actively is to flip old goods and furniture. Rather than finding properties and outlaying a large amount of capital, you buy less expensive household goods and furniture, fix them up, and sell them for a higher price.
Hourly wages are an active way to generate income because you must work to earn the wages. You only get paid for the hours you work. You can even control how much you make by taking on overtime or working as many hours as your employer allows.
Tips are common in service-related careers. Customers tip you money in exchange for your service. You are giving your time to generate money, so it's another one of the active income streams.
Passive Income Taxation
Some passive income earnings aren't subject to Social Security taxes, and others are eligible for certain tax deductions, especially real estate investments. As always, talk to your tax advisor about the taxability of your passive income vs. active income to see how it affects your bottom line.
Passive vs. Active Income FAQs
Is Passive Income Taxable?
All income is taxable, but you may not have to pay Social Security taxes on passive income. Some passive income earnings are also eligible for certain tax deductions, such as if you invest in real estate.
Why Is Passive Income Important?
Passive income diversifies your income streams. Rather than relying on one income stream, you can increase your net worth with multiple ways to earn money without burning yourself out. Passive income allows you to make more money than you could with the hours in your day.
What Happens if the Business Has Losses?
If you own a business generating passive income and it has losses, you may be able to write them off on your taxes. This reduces your tax liability since you have less income.
What Is a Passive Loss?
A passive loss is an investor's loss from an investment he didn't materially participate in.
How Does the IRS Determine What Is Passive and Active Income or Losses?
The IRS defines passive income as any income earned you didn't materially participate in. They'll ask specific questions about your income to determine if it's passive or active and tax it accordingly.
What Are the 3 Types of Income?
The 3 types of income are: earned, passive money, and investment. Earned income is money earned from working, passive income is money earned from investing in businesses or real estate that earn money, and investment income is money earned in your investment portfolio.
How Do I Make Passive Money?
There are many ways to make passive money, but investing in real estate is the most common. You can invest directly in real estate or participate in crowdfunding, to invest in commercial real estate properties with other investors. The rental income and eventual capital gains are passive forms of income.
Is Rental Income Active or Passive Income?
The IRS considers rental income passive income no matter how much you participate in property management.
How Can I Make $1000 a Month in Passive Income?
To make $1,000 monthly in passive income, diversify your efforts. Don't rely on one source or investment to provide your needed income.
Different Income Streams - The Bottom Line
Having different income streams is important to your net worth. When considering passive vs active income, have both in your arsenal. This offsets any losses one income stream experiences and ensures you meet your financial goals. Learn more by signing up and visiting our blog.
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