Active Income and Passive Income – What do they mean?
No matter what method you use to earn a living, the money you earn will fall into one of two categories: passive income or active income. While you may have heard these two terms before, many people aren’t sure what they mean.
Broadly speaking, the most common types of income are Earned, portfolio, and passive.
1. Earned income or Active income
The money earned in exchange for performing a service is referred to as active income.
Also known as Earned income, it is the income that one earns while working on a full-time job or running a business. It does not include rental real estate business, rather it comprises wages, tips, salaries, or commissions. This income is subject to high taxes.
It involves exchanging time for money, for example, if a person works as a web designer, he is paid a predetermined amount of money in exchange for a certain amount of time put into his job.
Most often, earned money is just enough to cover basic monthly expenditures, leaving little to no money left to invest.
2. Passive income
If someone told you that you could put in some upfront effort into something that will generate income for years, nobody would say no to that. That’s the idea behind passive income.
Passive income is money obtained from a past investment or an activity completed in the past, that continues to create money without requiring any additional effort.
It is the income earned by way of rents derived from real estate/property, royalties from patents or license agreements, interest income earned from bank deposits, and profits derived from stakes in limited partnerships. Passive income acts as an asset, i.e., an asset puts money in your pocket regardless of whether you work or not.
Here, money or revenue is typically obtained on a regular basis with little or no additional effort required. Passive income is taxed less than both the ordinary earned income and portfolio income.
3. Portfolio income (part of passive income)
Portfolio income refers to the income which is made through capital gains. It comprises income earned from dividends on shares, interest, and capital gains arising from the sale of stocks.
For example, when someone purchases a stock at a certain price in a company, they expect to sell the same stock at a higher price in the future. Suppose, if they purchase a stock today at $100, and when they sell the stock, the stock price goes up to $400; they make $300 in capital gains. This capital gain is their profit. They invest money in stocks that they feel are now undervalued with the expectation that they will be able to sell those same stocks for a capital gain when the prices rise.
Key Note: Portfolio income can be called a subset of passive income.
How is active income different from passive income?
|Active income||Passive income|
|You are doing something (some work, devoting time, energy, or effort) in order to receive that income.||You are earning a regular source of income with little to no effort required to keep it coming.|
|Income received from performing a service or from business in which there is material participation||Income from a business in which the taxpayer does not materially participate|
|Does not lead to financial freedom; the hustle to work never stops||This leads to financial freedom; eventually generates more idle time|
|Sources can be: |
– Salary, wages, commissions, and tips
– An active business in which the majority of the work is done by the taxpayer
|Sources can be: |
– Rental properties (collecting rent from tenants)
– Limited partnership, or other enterprises in which a person is not actively involved
– Dividends on stocks and interest on loans
– Peer-to-peer lending (P2P)
– Capital gains
|– Typically carries a lower risk |
– When you are participating in an activity to derive income, the risk exposure is minimum
|– May involve a relatively higher risk |
– Risking capital to try to earn passive income
|– Active income is more predictable |
– Makes it easy to plan a monthly budget
|– It may be comparatively unpredictable|
|May make individuals complacent and/or risk-averse||Individuals believe in risk-taking and discovering new opportunities|
|Can limit earning potential||Does not limit earning potential|
From Job Dependency to Passion Dependency
Rich people (with strong passive income) can still work for money, but they have virtually zero dependencies on their job/employment earnings. They are financially independent. And if they stop doing jobs, their passive earnings will take care of all life’s needs. Financial independence is that stage of life where you are no more dependent on your job to manage your needs of life. But attaining financial independence through a job has a low success rate.
Most people fail to enjoy financial independence since they don’t leave the clutches of their job. It takes time to build an income that replaces your job income or becomes a job replacer.
Nevertheless, everyone can take steps to move from job dependency to passion dependency.
For example, to generate $100 from a job, you put in 100% effort. Say if you follow your passion that generates an equal income of $100, the difference would be that you shall have to put in less effort as you relish your passion. It could be 20-30% effort for generating $100.
Earnings are capped no matter how hard one works as the salary is fixed. This means if you get $40,000 a month, you shall still get $40,000 irrespective of the amount of effort that you put in. However, if you work towards your passion, there is no limit to your earnings and it can be envisaged as you are generating income by doing nothing.
To sum up, passive income entails the following principles:
- Earn money from your passion
- Invest part of that income into buying assets
- Such assets generate passive income
- Identifying quality asset
- Buying them at an undervalued price
- Keep accumulating such assets all life
These days, there are a plethora of options available to generate passive income. Some examples to earn passive income from multiple streams of revenue can be:
Blogging: Most of the blogs employ Google AdSense, which offers a monthly revenue stream based on ads that Google places on the site.
Affiliate marketing: Website owners, social media influencers, or bloggers promote a third party’s product by including a link to the product on their site or social media account, in exchange for a commission. The most well-known affiliate partners are Amazon, eBay, Awin and ShareASale, etc.
Freelance business: One can freelance their passion to Crowdsourcing Sites like people per hour, Upwork, Project4Hire, etc. You can publish your artwork on crowdsourcing sites or even create your profile.
YouTube channel: As long as your videos are being watched, YouTube income is passive after the video is posted. As your video library and views grow, so will your income.
Dividends on stocks: Passive income is earned by picking dividend-paying stocks or ETFs for equity investment. One can become shareholders in companies with dividend-yielding stocks and receive payment at regular intervals from the company. Companies can also pay cash dividends quarterly out of their profits.
Others: The list is endless. However, some other options are investing in rental properties; investing in money market funds and mutual funds; investing in a high-yield certificate of deposit; becoming a silent business partner; listing your property on any number of websites such as Airbnb, and fixing the rental terms; investing in bonds or debentures; self-publishing on Amazon; creating an App; distributing, promoting and selling online courses through websites like Udemy, Skillshare.com, and Coursera; building an e-commerce store, etc.
Which is more important – active or passive income?
Passive income is crucial since it allows you to earn money without requiring your physical presence or continuous effort all of the time. In other words, if you have a passive income source, you can make money at every hour of the day and every day of the year. In reality, passive income has the potential to support your lifestyle for a very long period.
At the same time, one must keep in mind that passive income, in most cases, takes years to build. Whether you are investing, building an online audience through a blog, or saving up the cash to buy a rental property, there is a lot of early — active — work that goes into creating passive income.
Active income is important because it enables you to earn money quickly and consistently. In the majority of circumstances, passive income would not be possible without first generating active income. Sure, with active income – you won’t make money while you sleep. However, it will cover the cost of your bed while you work to build your passive income over time.
Hence, active income provides people with the means to build a passive income.
Thanks for reading !
You may also like: