Passive income is a trending word nowadays, but what is passive income after all? What is the difference between active and passive income. Learn more in detail in this active vs passive income comparison.
Regardless of the college or high school you went to; it’s likely that they didn’t teach you much about financing and money-making.
However, as you step into practical life, it’s crucial to be familiar with these things, especially once you’re required to be financially independent.
Keeping it short and simple, all money falls into two categories: active income and passive income. Both these kinds have their own benefits and long-term results.
In this active vs passive income comparison, you’ll learn the difference between the two and how you can earn from both streams individually or simultaneously.
So, let’s dive right into it.
Table of Contents
What Is Active Income?
Active income refers to the money you earn by actively performing a duty or service. It includes commissions, tips, wages, and salaries from the job/s you’re actively doing.
The most common type of active income is the paycheck you get from your employer. However, active income isn’t limited to that since some other factors also come into play.
For an income to be considered active, it must pass the Material Participation Tests by the Internal Revenue Service in the US.
Material Participation is a criterion set by the IRS to determine if a taxpayer materially partook in an income-producing activity, including rental, business, or trade. To prove material participation, a taxpayer has to pass at least one of the seven tests.
Material Participation Tests
The taxpayer or their spouse should meet one of the material participation tests to qualify a venture as an active income.
Although there are seven material participation tests, here are the three most integral ones that form the basis of others too.
- The taxpayer participated in the venture for over 500 hours in the tax year.
- The taxpayer was substantially involved in business activities.
- The taxpayer was involved in the venture for 100 hours, and no other individual in the business worked for more than 100 hours.
The material participation tests can be a bit tricky to understand since the time spent on a business does not always count in the number of hours.
For example, if you’ve spent time as an investor, it would not count in your 500 or 100 hours unless there’s proof of your direct involvement in the management activities of the business. Moreover, any time you spend commuting is not counted in the duration.
As an owner, any work you don’t do customarily is not counted in the material participation hours. Most importantly, if you participate in a managerial activity in a way that other managers do not get any compensation, it does not count towards your total hours.
Even if you own a business, it’s not considered your active income unless you’re actively participating in it. Simply put, you should be working to make the money instead of getting capital benefits without putting in active participation.
Active vs Passive Income: A Simple Example
Here’s a simple example to explain how two people working in the same company, being co-owners, can have different types of income. For instance, A and B have an online business with a 50% interest each.
A does most of the work, like packaging orders and dropping them off for shipping. The IRS would consider his income as active.
On the other hand, B also contributes to the business but in the marketing department. B works under 100 hours a year. Thus, her income would be called passive by the IRS even though she puts in work.
The material participation rule helps stop people who’re not actively participating in a business from leveraging their work to generate tax losses and write them off.
Examples of Active Income
It’s easier to explain what is the difference between active income and passive income once you know their examples. Here are some activities that the IRS considers active income.
Whether you work at a McDonald’s or a multinational corporate firm, if you pull a nine to five daily, your income is active. Essentially, you’re putting hours in a particular job, being an active participant.
Basically, you are earning money for the effort and time you’re putting in your work. Plus, you’re also present at the site. However, keep in mind that the time you take to commute to and from work is not counted in the material participation hours.
2. Hourly Wages
Hourly wages are possibly the most common type of active income. You can make an hourly wage by working for a delivery app or as an assistant at the local pet shelter. If your annual hours are more than 500, you’re earning an active income.
One of the best things about working an hourly job is that you have a better chance of making some extra money.
If you’re working in the hospitality industry, you’ll most probably be earning from tips too. All the tips you get contribute to your active income.
Many people are under the false conception that you have to grind nine hours a day to earn an active income. Instead, commissions also count as an active source of work as long as you are putting in the required number of hours.
Real estate agents are an excellent example of this type. For example, if a real estate agent sells property worth $100,000 and their commission is 2%, they’re earning $2000 as active income.
5. Freelance Services
For example, if you have a flair for graphic design, you can earn up to hundreds of dollars for one high-end project on a freelance platform. While some people freelance as a side hustle, others have penetrated the market sufficiently to make their skill a primary source of income.
Importance of Active Income
In an active vs passive income comparison, one of the most important things to know is why each one is so important.
Active income is the first choice of most people because it earns you immediate money. Plus, if you have a contract-based job, you can keep making this money consistently for years.
On the other hand, passive income is often not entirely under your control. Therefore, you can’t possibly estimate your earnings for the month or year.
For example, billionaires like Jeff Bezos, Bill Gates, and Elon Musk keep changing positions on the ‘Richest People Alive’ list because of the spikes and drops in the share prices of their companies.
Since they’re working at an astronomical level, the difference does not affect them considerably. However, if you scale it down to a smaller level, your financial plans for the year could be affected by a difference in the passive income you make.
On the other hand, an active income lets you plan ahead of time since you’re certain about the amount you’re earning every month.
Secondly, active income lets you make money in a short period. On the contrary, your passive income source can take some time to kick off.
Often, people use the savings from their active income to build to invest in a passive income source. That’s why active income is the first resort for the common man.
What is Passive Income?
Passive Income refers to the earnings from a limited partnership, rental property, or a stream in which an individual does not actively participate.
Although usually taxable, the regulations are different for passive income.
Like active income, material participation tests also apply to passive revenues. If you do not meet any of the tests, your income is considered passive by the IRS.
Grouping Passive Income
If you’re fortunate enough to have multiple streams of passive income, you must know how to group them too. For example, let’s suppose you own three different properties – a house, warehouse, and shop – in different states.
Now, you can group them in one of the following four ways:
- According to their activity (they’re all rentals)
- Grouped by type (storage, residence, commercial)
- According to geography (different states)
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.
Examples of Passive Income
It’s understandable why passive income is so hyped. Imagine not actively working a day in your life and still making money. Sounds incredible, doesn’t it? Here are some ways in which you can earn a passive income.
1. Investment-Based Interest
Possibly the best and most lucrative way to earn a passive income is by investing in something. Moreover, it’s a smart way to save up for your retirement fund. If you’ve earned enough active income, you can invest it in stocks or businesses and get interest as a passive income.
Here’s an example. Let’s say you were consistently investing throughout your job period. If your retirement portfolio went up to $5 million, you’d get an annual income – at 10% return – of $500,000.
That’s more than most people earn with multiple jobs. With investment-based interests, you can earn this passive income without getting off your couch the whole year.
Most people think that they have to invest in thousands or millions to earn a passive income. Today, it’s a bit simpler than it was a few years ago. You can invest your pocket change too.
For example, Acorns has simple plans, allowing you to invest anything from $1 to $5 a month. It might not add up to much, but it’s a great place to begin.
Likewise, Robinhood is a platform for commission-free investing where you can buy stocks.
2. Affiliate Income
To earn an affiliate income, it’s best if you have a large following or a certain kind of influence over people. Today, companies pay referral commissions to YouTubers and social media influencers when customers click through their link to buy a product.
Suppose you’re an Instagram influencer with a following of 500 thousand. A skincare company reaches out to you and offers a discount code or link for your customers. Then, you share this information on your platform, practically advertising the company’s product.
In return, you’ll get a set amount of profit every time a consumer buys the product using your link.
You don’t necessarily need to be a social media influencer to make money through affiliate links. If you have a blog that gets substantial traffic, you can add relevant links to earn an income with every purchase.
Amazon runs one of the largest affiliate programs. For example, if you have a fitness blog or website, you can add affiliate links to fitness products on Amazon to build a constant stream of passive income through your audience.
3. Rental Income
Rental income is the most commonly understood kind of passive income since many people are involved in it. If you have a property, you can rent it to earn extra money.
Remember how we talked about passive income being more unpredictable as compared to active income. Here’s an example of that. If you don’t get a tenant for your property, you won’t earn anything for the month.
Moreover, building this passive income stream requires a huge upfront investment. You’ll have to buy a property before you can rent it out to make extra cash.
Also, you need to maintain the property, and that adds more cost. For example, if you have rented out a house, you may have to spend money on repairs or renovation every now and then.
Despite all these factors, it’s still an easier way to earn money than active income. While most people only restrict rental income to houses and shops, there are other things that you can rent too.
For example, if you have an extra pair of wheels at home that no one uses, you can sign up for Turo. It’s a car rental platform where you can make some extra money by sharing your vehicle.
4. Display Advertising
Speaking along the same lines as affiliate marketing, display advertising also requires you to have a following or an influence. You must have a blog or a YouTube account where you can display ads to make money.
Again, it’s a bit time-consuming initially. But once you’ve got a considerable audience, you can make enough passive income by running display ads.
If you don’t have a website or the time to invest in kicking one off, you can buy a ready-made blog or a running web business from Flippa. Web hosting is extremely affordable these days, with plans at BlueHost starting from $3.95 a month.
5. Online Courses and Tutorials
Online courses are another great way of earning passive income, provided you have a large following. For this source, you don’t need to be a social media celebrity or influencer. Instead, you just have to be good at your job.
If you have a knack for art and design, Skillshare is the best place to sell your course.
Similarly, if you’ve written an e-book about a skill, you can sell it on your blog or website. In doing so, you’re putting in effort just once.
After that, there’s no active participation from your side in that business.
Importance of Passive Income
Again, in an active vs passive income comparison, one has to know the benefits of both. Although active income gives you immediate money, it’s not always a lot of money.
On the other hand, passive income allows you to make bank without putting in any effort. You could be sleeping or enjoy a vacation in the Bahamas and still making money.
However, passive income takes time. You’ll have to invest money, time, and effort into setting it up.
For digital streams, you’ll have to spend months, if not years, to attract enough audience for a blog or website. The same goes for a YouTube channel too.
For investment-based projects, you need to spend a large amount of money upfront. As lucrative and convenient as it may be in the long run, passive income requires initial effort and cost.
Active vs Passive Income: Taxation Differences
When speaking of active income vs passive income, a common question that comes up is: is passive income taxable? To understand this, we need to consider two things.
First, what is the difference between active income and passive income? Second, how does the IRS tax people in the US?
Let’s discuss this in detail.
Income Tax in the US
Quite simply, the IRS has a tax code that gives different tax treatments to incomes, depending on varying factors. One of the critical distinctions in this regard stems from the treatment of revenues as ordinary or passive.
Active or ordinary incomes fall under the seven tax brackets set by the IRS. The taxable treatment in these tiers goes from 10% to 37%, with the latter having gone down from 39.6% after the 2018 tax reforms.
On the other hand, passive income may be more beneficial because it does not come under these brackets. Instead, passive income gets favorable rates due to long-term capital gains.
Can Passive Income Let You Save in Taxes?
The short answer is Yes. To understand this, you must know that the IRS classifies capital gains as short-term and long-term. While active income is a short-term capital gain, passive income is long-term.
The income tax rates for active income progressively go higher from 10% to 37%, increasing as you earn more. On the contrary, the rates for long-term capital gains only go up to 20%.
Therefore, if you’re earning a passive income, even if it’s more than another individual’s active income, you won’t have to pay a rate higher than 20%.
Examples In Practice
When people ask, is passive income taxable, they want to know if they ever have to pay a cent on their properties or investments. Well, you still have to pay taxes but not as much as someone who makes an active income.
Here’s an example. Let’s suppose you work at a corporate firm, and your income falls in the top tax bracket. The maximum rate you’d ever have to pay is 37%.
On the other hand, no matter how much money someone is making through their passive income, they’ll only have to pay as high as 20%. Now, that’s almost half the percentage that someone with a top-tier active income has to pay.
Another thing you need to know is that rental properties don’t enjoy the same income tax treatment as other passive incomes, although it’s not an actively-earned income. However, rentals have additional perks like qualified tax deductions and MACRS depreciation.
If you’re wondering why the IRS makes this difference, it’s due to the nature of the rental stream of earning.
You will continue to get money from your tenants irrespective of whether you play your part in maintaining the property. Although it’s a passive income, the IRS sees it under the at-risk rules.
Keeping these things in mind, it’s easy to see why people prefer to go for passive income in an active income vs passive income choice. With these tax savings, you can manage your financial needs and create wealth for the long-term.
After all, you need to secure your retirement too.
Passive vs Active Rental Income: Is It a Thing?
Some people are confused about rental incomes since they believe working on repairs of their property to be a contribution to the IRS-stated material participation hours. However, there’s no practical passive vs active rental income comparison since it’s a paradox.
Once again, rentals are passive income. Even if you go over to your tenant’s place to fix a leaky faucet, it won’t count as your working hours. You’re still earning money from a source that you’re not actively participating in, managing or running off.
However, if you have an agency where you run or manage rentals, your income will count as active. The same goes for the people who work in your company, provided they put in 500 hours a year.
Active vs Passive Income: Which is More Enjoyable?
In a passive vs active business income comparison, it’s understandable why passive income would always have the upper hand.
First, you don’t have to work every single day to make ends meet. Second, you’re most probably earning more money than people who grind every day. Third, a passive income can be your savings for the annual vacation or the retirement fund.
In any case, it’s an effortless way of making money. Who doesn’t like their bank to fill up while they binge-watch Netflix on a Monday morning?
However, that does mean active income cannot be enjoyable. The concept of enjoyable active income has been circulating a lot for the past few years.
While the previous generations merely worked to make money, people today want to find some joy in their job.
An enjoyable active income is simply defined as active work that you find enjoyable.
How to Enjoy Active Income?
The simple rule would be just to do what you love – only if it was that simple. A common cliché that most fresh graduates are fed is to follow their passion. However, it’s not good advice for everyone.
For instance, if you love playing the piano, you can’t simply leave your job and roam the streets looking for a place to play the instrument.
The inspirational stories you hear in motivational sessions are of the few people who managed to make it. Everyone doesn’t.
Instead, focus on finding what you’re good at. You don’t even have to be a pro. Once you figure out your liking, you can hone your skills and make it an enjoyable active income.
Along with enjoying, keep in mind that you’re not merely doing it for the joy – you also need to make money. For that, develop rare skills or learn things that are foresighted to be valuable in the near future.
For example, programming and design are all the rage these days. With businesses moving online and the whole world operating through phone screens, the demand for this talent is bound to increase.
If you’re interested in programming, you can make a decent living online from any freelancing site.
Active vs Passive Income: Which Is Better?
Now that you know what is active vs passive income, it’s time to decide the one that’s best for you. The decision depends on different factors, ranging from personal to financial.
Let’s take a look at things you need to consider when deciding between a passive vs active business income.
The common notion is that everyone prefers passive income. However, that’s not always true as some people are content with their active income and would rather have money in their bank account than investing in a property or stock.
But then again, other factors, like taxation and savings, must also be considered. Is passive income taxable? It definitely is. However, you don’t have to pay as much tax on it as you would on a top bracket active income. That could be an inspiration to move towards passive income.
Or you may want to hustle for a decade or two of your life and then enjoy a slow and easy time. In that case, you should work actively initially while building a passive income on the side.
Not everyone has the finances to build or invest in a passive income. When choosing between the two, you have to make some decisions.
For example, let’s say you have three kids, and the eldest is about to go to college soon. Would you invest your savings from the active income in a stock or your kid’s education?
Depending on your expenditure for the month, you may not have any savings left to invest in a passive income. In such situations, you’re forced to depend on your active income.
Another thing that affects your active vs passive income decision is the skills you have. If your qualifications have prepared you to be a lawyer, your best resort would be to work actively in a law firm or set up your practice. In both cases, it’s an active income.
Similarly, doctors, engineers, teachers, and other professionals earn an active income.
On the other hand, if your skills include makeup, design, or programming, you can earn a passive income by selling courses or displaying ads on your social media channels.
Although professionals can also develop side skills to grow their passive income, it would take extra time and effort.
What Is the Difference Between Active Income and Passive Income? A Brief Overview
After reading this guide, you should be able to make a decent active vs passive income comparison. In short, what is active and passive income?
Active income refers to the money that comes from your active participation in a business. On the other hand, you earn passive income from bonds, mutual funds, stocks, rentals, and streams you’re not actively participating in.
Active vs Passive Income: What’s the Bottom Line?
To end this active vs passive income review, we’d say that both these incomes are equally important to maintain a global economic ecosystem. Therefore, we can’t say one is better than the other.
However, you can personally prefer passive over income or vice versa. In this guide, we made an in-depth active vs passive income comparison to explain how they differ. Moreover, we mentioned examples and methods of earning through both streams.
With this information, you can now have a better understanding of how to make money and manage it via different means. Plus, it’ll also help you learn how some people save on taxes and why their wealth generation is speedier than an ordinary Joe’s.
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