A critical factor in attaining financial independence and creating wealth is comprehending the distinction between active and passive income. Both types of income have pros and cons regarding the effort and involvement required to earn money. Active income is generated through providing services, such as employment or entrepreneurship, while passive income is achieved without the needed immediate time.
Active income is often considered the more traditional form of income. It requires you to trade your time and effort for money. This means that if you stop working, you stop earning money. Passive income, on the other hand, allows you to make money while you sleep. Once you set up a passive income stream, it can continue to generate income for you without requiring much ongoing effort.
While both types of income can be valuable, understanding their differences can help you make smarter financial decisions. By building an extra source of income through passive income, you can create a more stable and sustainable economic future for yourself. Here, we will explore the differences between active and passive income and how to use them to achieve your financial goals.
Portfolio Income is another type of income, but for this article, we will not touch on this here.
Later on in this article, we will get into our take on how we are working on balancing active and passive income through our financial freedom investing strategy.
Key Takeaways:
- Active income requires trading time and effort for money, while passive income generates money with little ongoing effort.
- Active income includes salaries, wages, commissions, and business ownership, whereas passive income involves rental properties, investments, and minimal involvement in business ventures.
- The IRS uses material participation tests to determine if income is active or passive, such as the 500-hour, 100-hour, and facts and circumstances tests.
- Passive income can be grouped into three main categories: rental, investment, and business.
- Active and passive income have different tax treatments, with real estate investors benefiting from more favorable tax deductions and credits for passive income.
- Active investing can generate higher income and offers more control but may require long hours, less flexibility, and more upfront capital.
- Balancing active and passive income streams, such as investing in rental properties, can lead to long-term financial stability and independence.
What Is Active Income?
Active income is earned through active participation in work, regardless of employment, including salaried or hourly, owning a business, or earning commissions or tips. It is the compensation received for the time and effort invested. Active income differs from passive income because it requires active involvement in generating income.
The most common type of active income is when people work for a company and receive a salaried or hourly wage in return. The more skills you can bring to the table with that company, the better you get paid.
Material Participation Tests
The IRS has specific rules to determine whether income is active or passive. One key factor is material participation. The IRS defines material participation as “regular, continuous, and substantial involvement in the operations of a business or trade.” In other words, if we are actively involved in the day-to-day operations of a business or trade, we are considered materially participating and earning active income.
There are several tests to determine material participation, including:
- The 500-hour test: We must participate in the activity for at least 500 hours during the tax year.
- The 100-hour test: We must participate in the activity for at least 100 hours during the tax year, and our participation must be more than any other individual.
- The facts and circumstances test: This test looks at the nature of our involvement in the activity, our expertise or knowledge, and the amount of time we spend on the action.
Active vs Passive Income: A Simple Example
Let’s say we work as an employee at a retail store, earning an hourly wage of $15. This is an example of active income because we exchange our time and effort for money. If we work 40 hours a week, we earn $600 a week before taxes.
Let’s say we invest in a rental property and earn $500 monthly rent. This is an example of passive income because we are not actively involved in generating income and still make money even if we don’t do anything. However, we still need to participate to be considered active income materially.
Active income is the money we earn by actively participating in work, while passive income is typically money we earn without active participation. Understanding the difference between active and passive income can help us make educated decisions about our finances and investments.
What is Passive Income?
Passive income is a type that is earned without the need for active involvement. It is money made from investments, rental properties, or other sources that require little to no effort once the initial work is done. Passive income can be a fantastic strategy to supplement your active income and achieve financial freedom.
This type of income is commonly referred to as residual income, but the names are used interchangeably.
Grouping Passive Income
Passive income can be grouped into three main categories:
- Rental Income: This is income earned from renting out the property such as apartments, houses, or commercial buildings. Rental income can provide a steady income stream without requiring much effort once the property is rented. This is our preferred passive income type, as you can follow investing steps by purchasing real estate assets to grow it.
- Investment Income: Income earned from stocks, bonds, or mutual funds. Investment income can be acquired through dividends, interest, or capital gains.
- Business Income: This is income earned from a business where you have little to no active involvement. This can include owning a rental property or being a silent partner in a business venture.
Passive income can also come from other sources, such as royalties, leasing, or affiliate marketing. It is important to understand that while passive income may require less effort than active income, it still requires initial work and investment to generate income streams.
Passive income can offer many benefits, including the potential for financial freedom and the ability to earn money while you sleep. However, it is crucial to keep in mind the tax implications of passive income and ensure you are taking advantage of any available deductions.
Passive income can be a fantastic way to supplement your active income and achieve financial freedom. By investing in income-producing assets and taking advantage of available tax deductions, you can create a steady stream of passive income that can potentially provide financial security for years to come.
Active Income vs Passive Income: A Simple Example
We can use the previous example for a passive vs active business income comparison. In that example, B worked less than 100 hours a year, although she contributed to the online business through her marketing skills.
However, she was not actively working in the day-to-day activities of the business.
Therefore, B was earning a passive income among the duo.
Active vs Passive Income: Taxation Differences
Income Tax in the US
Active and passive income receive different treatment under US income tax laws. Wages, salaries, and commissions are usually subject to ordinary income tax rates. Passive income, like rental or capital gains, may have different tax rates and treatment. Real estate investors have access to more deductions and credits, making the tax treatment of passive income from real estate more favorable. The taxpayer’s overall income level may also determine if the tax rate for passive income is lower than for active income.
Active vs Passive Income Real Estate
Benefits and Disadvantages of Active Investing
Active investing can provide many benefits, such as owning a business, consulting, or running a website. For one, active investing can generate higher income than passive investing.
Additionally, active investors may have more control over their income and can deduct more expenses from their taxable income.
However, active investing also has its disadvantages. For example, active investors may have to work long hours and have less flexibility than passive investors. Additionally, active investing may require more upfront capital and be riskier than passive investing.
Benefits and Disadvantages of Passive Investing
Passive investing, such as investing in stocks, bonds, or real estate partnerships, can also provide many benefits. For one, passive investing requires less time and effort than active investing. Additionally, passive investors may have more diversification and be able to generate income without working.
As we see it, the main advantage of this approach is it is detached from time. Whatever the source of
However, passive investing also has its disadvantages. For example, passive investors may have less control over their investments and may not be able to deduct as many expenses from their taxable income. Additionally, passive investing may require more upfront capital and be subject to market volatility.
Whether to pursue active or passive income depends on the individual’s goals, risk tolerance, and financial situation. It is essential to understand the tax treatment and benefits and disadvantages of each type of income before making a decision.
Our Approach To Active vs. Passive Income After 40
My wife and I believe in balancing active and passive income streams as investors. While active income is essential for covering our day-to-day expenses, we recognize the significance of passive income in achieving long-term financial stability.
Our active vs. passive income approach focuses on investments that generate passive income. Specifically, we invest in single-family rental properties to build a reliable and steady income stream.
We have articulated this into a more concrete financial freedom plan. By investing in this manner, we are creating a more balanced income that provides both active and passive income, allowing us to achieve financial freedom, focusing on cash flow exceeding our expenses.
Frequently Asked Questions (FAQs):
Q: What is the difference between active and passive income?
A: Active income requires active involvement and is typically earned through employment or business. In contrast, passive income is money made with little to no active participation, often from investments or rental properties.
Q: What are some examples of active and passive income?
A: Functional income examples include salaries, wages, and business ownership. Passive income can come from rental properties, investments, or businesses requiring minimal involvement.
Q: How can active and passive income contribute to financial freedom?
A: Balancing active and passive income streams can lead to long-term financial stability and independence. Active income can cover day-to-day expenses, while passive income, like investments, can build wealth over time.
Kurt has gone from the financial lows of the ’08 financial crisis to personal financial success. He is a professional real estate investor, media buyer, faithful Red Sox Fan.
One of his passions is financial education and the pursuit of financial freedom.
You can learn more about Kurt here, or get a hold of him on Facebook or Twitter.
