Income is money earned, plain and simple, right? While that statement is true, it doesn’t tell the full story. If you look a little more closely, you’ll learn that there are two kinds of income. Active income is money you make by actively participating in work, whether you are salaried or hourly, employed or own your own business, earn commissions or tips, and so on.
Passive income, on the other hand, is typically money that you earn without active participation. Examples might be money generated by a rental property you own or a YouTube account you started but haven’t updated.
It’s important to know the difference between the two for multiple reasons, including the fact that the IRS treats active and passive income differently. Both are taxable, but in distinct ways, so it’s important to correctly classify each.
To understand active income vs. passive income, read on. You’ll learn:
• What is active income?
• What is passive income?
• Examples of passive vs. active income.
• Why it’s important to know the difference between active and passive income.
What Is Active Income?
Active income requires you to take action to make money. Working a 9-to-5 job, earning tips as a cosmetologist, and driving for a rideshare app are examples of this principle in action. All require active participation to earn money and are thus considered active income.
Most people (i.e., those who don’t inherit money or come into a large sum of money without effort) will need to earn active income to pay bills and build their savings. Active income is often dependable in quantity and schedule (e.g., a regular paycheck for a salaried position).
With enough active income, you may be able to invest in something that generates passive income down the road (you’ll learn more about that kind of money in a moment).
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Examples of Active Income
Earning active income is something that so many of us do — from doctors to mail carriers, from plumbers to programmers. Even people who own their own business, work side gigs, or rely mostly on tips earn active income.
Here are the main sources of active income:
• Hourly wages
• Income from invoices as an independent contractor
• Sales commissions
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What Is Passive Income?
Passive income can be more difficult to define because the IRS has a long list of qualifiers that can be a bit challenging for the average person to understand. At a high level, the IRS guidelines for passive activities are as follows identifies two kinds of passive activities:
• Trade or business activities in which you don’t materially participate during the year
• Rental activities, even if you do materially participate in them, unless you’re a real estate professional.
The key phrase to consider in the IRS’s definition of passive income is “materially participate.” The IRS has a list of seven tests (“material participation tests”) to apply to your income to determine if you actively participated in generating it.
These tests measure things like hours of activity (500+ hours in a year automatically makes it active income) and level of involvement.
You only have to satisfy one of the seven tests for your income to be considered active — which has tax implications. That’s why it’s wise to work with an accountant to properly define your income.
Examples of Passive Income
Because the IRS has strict rules regarding the classification of passive income, things get complicated. An activity could be classified as active for one person but passive for another. It comes down to how you participate.
With that caveat in mind, there are some top ways to make passive income:
• Renting a space: Whether you are renting out an entire property, renting a room in your home, or even renting a garage or parking spot, the income can be classified as passive.
• Affiliate marketing and ads: If you have a high-traffic website that does not require regular content creation to drive traffic, you can earn passive income through affiliate marketing (adding specific links to products or services) and through display ads.
• Licensing intellectual property: If you’ve written a book, designed an online course, taken high-quality photos, or even engineered an app, you might be able to earn royalties whenever someone purchases your creation.
• Cash back from a credit or debit card: If you are using a cash back credit card for everyday purchases, that “free money” can serve as passive income. But remember, with cash back, you’ve got to spend money to make money. Nice to know: The IRS views cash back on rewards cards as a coupon or rebate, which means you don’t need to worry about tax implications.
Some personal finance blogs might tell you that interest, dividends, and earnings from investments are passive income. After all, you just put your money in an account, and the money (usually) grows on its own; you don’t have to expend any effort. However, the IRS classifies this as “portfolio income,” and it has its own separate tax implications.
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Active vs Passive Income: What’s the Difference?
So what is the difference between passive and active income? Generally speaking, you have to actively and continually work to keep active income flowing into your bank account. Passive income often requires labor and financial investment upfront, but once everything is in place, passive income should flow to you without the need for much, if any, effort.
A strong example of active vs. passive income is flipping a house vs. renting out a house. Consider the difference:
• If you regularly buy houses, renovate, and sell at a profit, you are making active income. If you stop buying and selling houses, the income stops.
• If you buy a property and rent it out to tenants, you have a passive income stream flowing in each month — with occasional expenses like property taxes and maintenance.
Broadly speaking, passive income might refer to interest and dividends, royalties, money made from digital content creation, rental properties, and more. But as far as the IRS is concerned, passive income has a much narrower definition. It’s a good idea to work with a certified accountant to understand how your income should be classified and taxed.
Next, take a closer look at the differences between the two types of income.
Potential Yearly Income Made
Active income is generally more dependable, especially if it’s from a salaried or hourly job with a set number of weekly hours. Thus, it’s easier to predict your yearly income.
Certain types of passive income, like rental income, might be more predictable than others, but you still might encounter unexpected expenses like maintenance and repairs or sudden vacancies. Other types of passive income, like money from display ads or affiliate marketing, depend on the number of people who visit your website and actively click links.
How These Are Taxed
Taxes on active income are generally straightforward. If you’ve paid taxes before on hourly or salaried wages, you’ve already paid taxes on active income. It’s a good idea to brush up on federal tax brackets before tax season.
Taxes on passive income are more complicated and can vary by situation. Income from real estate you lease out, for example, has its own rental property IRS regulations . If you earn passive income, working with a certified account can be a smart move to ensure you get your taxes right each April.
How These Incomes Affect Lifestyle
Active income requires that you regularly work to generate money. For the average American, that looks like a 40-hour work week, though some people may work part-time while others may typically put in more time on average.
Because passive income requires minimal (or no) participation, you might be able to lead a more flexible life. This assumes you have enough passive income flowing in each month to pay your bills and maintain a monthly budget. If that’s the case, you might be able to travel more freely, focus on volunteer work, or spend time doing your favorite hobbies. Or passive income might supplement your full-time active work, allowing you to save more for retirement or meet other financial goals.
Most Americans who work earn active income; that is, making money requires their active participation on an ongoing basis. Passive income, on the other hand, requires little to no involvement, meaning you might make money without lifting a finger, though often an initial investment of time and cash is required. The IRS has important qualifications for active, passive, and portfolio income (from investments); understanding the differences and how they are taxed is important when you file.
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What are the pros and cons of active and passive income?
A major benefit of active income is that it is usually dependable; however, you have to regularly and consistently work to earn that money. A benefit of passive income is that, after potentially investing time and money upfront, it requires little to no ongoing work. The cash may simply come your way. Worth noting: The tax implications of passive income can be complex and require professional guidance.
Do all people need to have passive income?
You do not need passive income to pay your bills; for many people, active income from their job will suffice. If you would like to infuse more flexibility into your life and earn additional income, it could be a smart move to generate passive income streams.
Can you live solely off of passive income?
It is possible to live solely off of passive income if you establish enough steady passive income streams to cover your expenses. Many passive income streams require work upfront and/or an initial investment, but once they’re going, they might be easy to maintain.
Is active income better than passive income?
Both active and passive income have pros and cons. Active income requires ongoing work but can mean a steady paycheck. Passive income may need an initial investment of time and money but can then keep cash flowing your way. Generally speaking, any type of income is good because it enables you to pay your bills, pay down debt, build your savings, and even invest.
Photo credit: iStock/Adrian Vidal
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