Income is money earned, plain and simple, right? While that statement is true, it doesn’t tell the full story. If you look more closely, you’ll learn that there are two kinds of income — active income and passive income.
Active income is money you make by actively participating in work, and generally comes in the form of salary, wages, commissions, and tips. Passive income, on the other hand, is money that you earn without active participation. Examples might be money generated by investments, a rental property you own, or a YouTube account you started but haven’t updated.
While passive income may sound like the better deal, both types of income are important. Read on for a closer look at the differences between active and passive income, including potential earnings, tax implications, and how they can impact your lifestyle.
Key Points
• Active income is the income you actively work for, such as through jobs, freelance work, gig work, commissions, and bonuses.
• Passive income, after it’s initially established, requires minimal ongoing effort and may come from investments, rental properties, royalties, and automated online businesses.
• Active income tends to be more predictable and secure but limited by time and effort, while passive income may grow over time.
• Active and passive income may be taxed differently, with active income typically taxed as ordinary income and passive income, in certain cases, taxed at lower rates.
• Combining active and passive income may boost financial security, improve work-life balance, and help you meet financial goals.
What Is Active Income?
Active income is the income you actively work for, such as a salary or hourly wage, and is the most traditional form of earning money. This type of income requires continuous effort, meaning you need to trade your time and labor for money.
Active income is typically tied to a specific time commitment, such as working 9-to-5. The amount of active income you earn also tends to be directly related to the amount of work you complete. Once you stop working, the income stops too.
With enough active income, you may be able to invest in something that generates passive income down the road (more on that below).
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Examples of Active Income
Active income can come from a number of different sources. Here’s a look at the some of the many ways you can earn active income.
• Your job: One of the most common ways to earn active income is through salaried employment. Whether you receive a fixed salary or an hourly wage in exchange for your work, your income is directly tied to the time and effort you put into your job.
• Freelance work: Since you are providing a service in exchange for pay, freelancing is considered a form of active income. Whether you’re a writer, graphic designer, programmer, or do any other type of contract work, you earn money only when you complete specific tasks or projects.
• Gig work: Taking on a side hustle like driving for a rideshare or food delivery service, or any other involvement in the gig economy, qualifies as active income.
• Commissions: Many professionals involved in sales earn active income through commissions. This type of income depends on performance, where you earn money based on sales or completed deals.
• Bonuses: Some jobs offer bonuses in addition to a regular salary. These bonuses are often tied to performance metrics and are considered active income since they require achieving specific goals.
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What Is Passive Income?
Passive income refers to money you earn with minimal effort or direct involvement after an initial setup. Unlike active income, which requires continuous labor, passive income flows regularly without the need to trade time for money on a daily basis. Passive income can come from investments, royalties, or business ventures where you’re not involved in the daily operations.
While passive income often requires upfront work or capital investment, the idea is that the income will continue to flow with little or no day-to-day labor. This type of income is appealing because it can help you build wealth and financial security over time.
Examples of Passive Income
Like active income, there are a number of ways to earn passive income. Here are some of the most common sources of passive income.
• Dividend stocks: Dividend-paying stocks offer a way to earn passive income by investing in shares of companies that distribute part of their profits to shareholders. Investors receive regular dividends without needing to manage the company.
• Bank interest: When you deposit your money into a savings account, you earn interest just by letting it sit there — the ultimate form of passive income. The higher the interest rate, the more you can earn. High-yield savings accounts offered by online banks typically generate more passive income than traditional savings accounts.
• Rental Income: Owning real estate and renting it out is a popular form of passive income. Once the property is rented, the owner collects monthly rent without much day-to-day involvement, especially if they hire a property management company.
• Royalties from intellectual property: Authors, musicians, and inventors can earn royalties from their intellectual property. Once a piece of work is published or a patent is licensed, the creator can receive passive income from each sale or usage.
• Automated online businesses: E-commerce stores that use drop shipping or automated sales systems can generate passive income. Once the system is set up, little involvement is required to maintain the flow of revenue.
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Active vs Passive Income: What’s the Difference?
Active and passive income serve different purposes and offer distinct advantages and disadvantages. Here’s a look at some of the key differences.
Potential Yearly Income Made
Active income is generally more dependable and predictable, especially if it’s from a salaried or hourly job with a set number of weekly hours. However, the potential for active income often depends on how much time and effort you can dedicate. The ceiling for active income may also be capped by your line of work and industry standards.
Passive income, by contrast, can be hard to predict and is generally less dependable, since it may be susceptible to market volatility and other external factors. However, the potential for income can be higher, since earnings aren’t limited by how much you can work. Once established, a source of passive income can continue to generate money indefinitely and potentially provide a significant annual income stream.
How These Are Taxed
Active income and passive income are taxed differently by the internal revenue service (IRS). Wages, salaries, and commissions are all taxed as ordinary income, meaning they fall under the standard federal and state income tax brackets.
The tax rate on passive income, however, can vary, depending on how it is earned. For instance, long-term capital gains (from selling investments held for more than a year) and qualified dividends are generally taxed at lower rates than ordinary income. However, rental income, interest payments, and royalties may be taxed at ordinary rates.
Since this is a complicated area of tax law, it’s a good idea to work with a licensed tax professional when managing taxes for passive income streams.
How These Incomes Affect Lifestyle
Active income requires that you regularly work to generate money. People who rely solely on active income are typically bound to a fixed schedule, which can limit flexibility and put limits on leisure time.
Because passive income requires minimal (or no) participation, it can lead to a more flexible lifestyle. However, this assumes you have enough passive income flowing in each month to pay your bills and other expenses. If that’s the case, you might be able to travel more freely, focus on volunteer work, or spend time pursuing personal passions. Or, passive income might supplement your full-time active work, allowing you to save more for retirement or meet other financial goals.
The Takeaway
Many people rely on active income, which requires active, ongoing participation in the workforce and related to how much time you can dedicate to working. Passive income, by contrast, provides the opportunity for ongoing earnings with minimal effort after the initial setup.
While active income is generally more predictable and secure, passive income can help you build financial security over time and improve your work-life balance. Even if active income is your main source of income, generating some degree of passive income can boost your emergency savings and help you meet your short- and long-term financial goals.
Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.
FAQ
What are the pros and cons of active and passive income?
Active income provides immediate, predictable earnings but requires continuous work. A key benefit of this type of income is a dependable paycheck, but it’s limited by your available time and energy. If you stop working, the income stops too.
Passive income, once established, requires minimal ongoing effort. The downside is that it often takes time, capital, or initial effort to set up, and the income may be less predictable at first. Over time, however, it can grow and supplement active income without any increase in daily labor.
Do all people need to have passive income?
You do not need passive income, especially if you’re content with your career earnings and you’re building savings for the future. That said, having passive income can be beneficial. After the initial setup, passive income allows you to earn money without much additional effort. Passive income can supplement active income and allow for more flexibility and financial freedom.
Can you live solely off of passive income?
Yes, living solely off passive income is possible, but reaching this goal often involves years of saving, investing, and cultivating sources of passive income. Many people strive for this through financial planning and investments that eventually generate enough income to cover living expenses.
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 typically requires an initial investment of time and money and may be less dependable than active income. Once established, however, passive income can then keep cash flowing your way without ongoing work. Ideally, you want to have both active and passive income.
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