Active Income vs. Passive Income

Unlocking financial freedom may seem like a daunting task, but it can be done by correctly implementing a financial strategy based on active and passive income. While active income requires more direct hands-on work, passive streams automatically generate income without you having to work for it. By understanding and leveraging the power of both active and passive income, individuals can attain their financial goals, adapt their lifestyles, and optimize their tax strategy. A financial advisor can help you identify ways to generate both active and passive income.

What Is Active Income?

Active income is money earned through work, such as a salary, self-employment income or commissions. It requires direct involvement in providing services or labor. Jobs or careers that generally generate active income include doctors, engineers, teachers, salespersons and graphic designers.

Types of Active Income

Active income can come from a variety of sources, including salaries and wages, self-employment as well as commissions and bonuses.

Salaries and wages. The most common type of active income comes from salaries and wages, which are the regular payments individuals receive for doing their jobs. This form of income requires direct involvement and time investment in work-related activities. Many consider this to be trading your time directly for money.

Examples of specific jobs and their median annual salaries include software developers ($109,020), registered nurses ($77,600), and high school teachers ($61,820), as reported by the Bureau of Labor Statistics.

Self-employment. Income that comes from self-employment, including consulting and freelance work, also falls under the category of active income. Instead of a company or organization compensating you for your time and work, self-employed workers generate their own business. It’s important for these types of workers to understand the intricacies of self-employment taxes and deductions, as well as navigate the fluctuating nature of self-employment income.

Commissions and bonuses. These are additional payments earned based on individual achievements, such as sales or project completion. This type of income can vary greatly and depend on the individual’s productivity and success.

What Is Passive Income?

While active income requires you to trade time for money, passive income is the money that’s automatically generated by the assets you own, a product you’ve created or a system that you’ve set up. Then again, passive income isn’t free money. It requires an initial investment or some upfront effort like buying stocks or purchasing and maintaining a rental property.

Types of Passive Income

Like active income, passive income can flow from different types of streams. Common types of passive income include dividends and interest, rental income, royalties and capital gains.

Dividends and interest income. Dividends and interest income are common forms of passive income. For example, if someone were to invest $10,000 at a 5% annual interest rate for 20 years, it could potentially grow to over $26,500. Examples of companies with a good track record of paying dividends include blue-chip stocks such as Procter & Gamble, Johnson & Johnson and McDonald’s.

Rental income. Rental income is another form of passive income where individuals earn money from renting out properties. It is essential to find the right rental property and manage it well to maximize passive income. Rental property investing strategies include targeting high-demand areas and focusing on cash-flow-positive investments.

Royalties. Royalties are the income that’s earned from allowing others to use one’s creative or intellectual property. Monetizing intellectual property or creative works for earning royalties can involve writing books, composing music, developing software, licensing patented inventions or creating educational material.

Capital gains. Capital gains on stock investments or real estate, such as purchasing a property and selling it for a profit, can also bring in passive income. For example, consider an individual who buys a house for $200,000 and sells it later for $250,000, potentially resulting in a $50,000 increase or capital gain. Regarding tax implications, understanding the potential impact of taxes on profit is crucial, as long-term capital gains (assets held for more than a year) often have lower tax rates compared to short-term capital gains or regular income taxes.

Major Differences of Active vs. Passive Income

While both active and passive income streams may play a significant role in your financial plan, there are significant differences between them, including how they’re taxed and the risks involved with each, among others.

How they’re taxed: Active income is often taxed at higher rates compared to passive income. For example, long-term capital gains and qualified dividends receive more favorable tax treatment than salary and wages, which are taxed as ordinary income.
How each income affects your lifestyle: Active income requires constant work and effort, while passive income allows for more available time, as it is less tied to labor and effort.
Risk Involved: The stability of active income for salaried employees can make it more predictable and reliable compared to the uncertain returns on passive income investments, which may be more susceptible to market volatility and other external factors.

How Combining Active and Passive Income Helps You Earn More

Leveraging both active and passive income streams can help you earn more and achieve financial goals faster. For example, a person with a salaried job who owns several rental properties can live off the wages from their full-time job and put their rental income toward long-term savings goals or use it to invest in new passive income streams. Here’s how combining active and passive income sources helps you improve your financial position.

Diversification of Your Income Sources

Having multiple income streams helps protect against financial uncertainties, such as job loss or investment changes. Examples of individuals who have successfully combined active and passive income streams include bloggers who rely on advertising, sponsored content, and affiliate marketing; landlords who engage in real estate rental income while maintaining a day job; or income investors whose portfolios supplement the earnings from their full-time jobs.

Achieving Financial Goals and Flexibility

Reaching retirement goals or financial freedom is more achievable when having a well-balanced approach to active and passive incomes, often with the guidance of a financial advisor.

Maximizing Tax Benefits

Combining both active and passive income sources can lead to potential tax advantages, such as the ability to offset capital gains with losses or tax-advantaged investment strategies. With a more diverse set of assets and income sources, you’re in a better position to take advantage of some favorable tax laws.

Bottom Line

Diversifying your income between active and passive sources can help you achieve financial security. While active income involves trading time and effort for money, passive income is money earned automatically from an investment, product or system that you’ve established. It’s crucial to tailor your approach to your unique financial circumstances, goals and resources in order to maximize the potential of both active and passive income sources.

Investing Tips

If you need help picking investments or managing your portfolio, consider speaking with a finance professional. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Keep in mind that there are different ways that investments are taxed. When you sell a stock or another asset, it’s considered a capital gain and treated as such. On the other hand, if you collect interest or dividends from an asset, the proceeds are typically treated as ordinary income and taxed as such.