Jacob Wade
·5 min read
Passive income sounds magical, but is it really better than active income? And what exactly is the difference between active and passive income?
Discover: 6 Types of Retirement Income That Aren’t Taxable
Learn: How To Build Your Savings From Scratch
We’ll define both and show you the differences, including which types of income qualify as active and which are passive. Both incomes are required throughout your lifetime, but combining the power of both can help you reach financial independence much faster.
Active Income vs. Passive Income: What’s the Difference?
While both types of income require some sort of work, they are fundamentally different.
Active income requires you to materially participate in a work-related activity to earn money, while passive income comes from owning income-producing assets. You typically need to earn active income first to generate the funds needed to invest in passive income assets.
Take Our Poll: Would You Put All of Your Savings in an Apple Savings Account?
What Is Active Income?
Active income is the process of working for money and includes things like wages, salary, tips, commissions, freelance income, side hustle income and other work-related income. In most cases, you are trading your time for money.
What Is Passive Income?
Passive income includes earning income without being required to participate in a work-related activity. This includes income from sources like investments, dividends, real estate rentals, business ownership, online businesses, courses, downloadable content, existing YouTube channel, website display ads, affiliate marketing and more.
Examples of Active Income
Here are a few examples of ways to earn active income:
Your job. The most common way to earn active income is through your job. Whether you are paid hourly or an annual salary, you show up to work, do your job and get paid.
Your business. If you own a business and haven’t hired an operator and management team to handle all of the day-to-day tasks, then you are earning active income. If you are handling any aspect of the business operations, such as sales calls or providing a service, this is considered active.
Freelance work. Freelance work is considered active income, as you are providing a service for pay. This might include freelance video editing, writing, software development, legal consulting or any other type of contract work.
Gig economy work. Jobs like driving for Uber or Doordash, pet sitting, housesitting or other gig economy jobs qualify as active income.
Examples of Passive Income
Here are a few examples of ways to earn active income:
Traditional investments. Investing in the stock market puts your money to work, and you can earn interest, dividends and capital gains from your investments. This is a completely passive activity, allowing you to earn money without doing anything more than investing your funds.
Bank Interest. When you deposit your money in a savings account, you can earn passive income based on the account interest rate. Even better, finding a high-yield savings account will pay you a higher rate without having to lift a finger. This is truly passive income.
Dividends. Whether you earn dividends from investing in a stock or bond, or if it’s from a business you own, dividends are paid without you needing to work for them. For traditional investments, these are typically paid out on a quarterly or monthly basis.
Rental real estate. Rental real estate is one of the best ways to earn passive income, though you do need to invest funds (and time) into getting the property rented and managed. While real estate may require some of your time, once it is rented out and you hire a management team, it can be nearly 100% hands-off income.
Online income. While building an online business takes a lot of time, once you have established a system for generating leads and income, you can automate a lot of the process. For larger online businesses, hiring an operations and leadership team can help you simply collect income without participating in the business.
How Are Passive Income and Active Income Taxed?
Active income and passive income are treated differently by the IRS. While active income is typically taxed at your normal income tax rates (and taken from your paycheck directly), passive income taxes can vary, depending on how the income is generated.
Passive income can be taxed at a lower rate, at your regular income tax rate or even at a higher rate, depending on how it is earned. Because investment rules vary widely, it’s best to work with a licensed tax professional when managing taxes for passive income streams.
How Combining Active and Passive Income Helps You Earn More
While active income is the most common way to earn money, passive income helps you earn money without putting in any extra work.
But what if you did both?
Focusing on increasing your active income can help you save more money each month. You can then use the savings to invest in income-generating assets such as investments, businesses, rental real estate or even just depositing it into a high-interest account.
The more you invest into passive income, the higher your annual earnings will be. Eventually, your investments might outpace your active income, and then you will become financially independent, able to live on your passive income alone.
Here’s how combining your active and passive income can raise your overall income:
Hourly Rate: $20 an hour
Annual Income: $41,600
Invest 15% of income: $6,240
Over the next five years, if your investments provide an average return of 8% per year, you’ll end up with over $45,000. These funds earning 8% per year can now earn $3,600 in the next year. That’s the equivalent of giving yourself a $1.73 raise, without doing any extra work.
Bottom Line
Both active and passive income are necessary to increase your income and eventually be able to retire. You will most likely start with active income, working for a company, and then slowly transition to passive income over time.
Eventually, you will retire and live 100% on passive income. But you need to start investing in income-producing assets today to build your passive income. This is a long-term strategy — and one that’s required to have a comfortable retirement.
More From GOBankingRates
5 Expensive Renovations Homeowners Always Regret
Financial Insight in Your Inbox: Sign Up for GBR's Daily Newsletter
3 Ways to Recession Proof Your Retirement
14 Ways to Invest That Don't Involve the Stock Market
This article originally appeared on GOBankingRates.com: What’s the Difference Between Active and Passive Income, and Why Should You Care?
