Active vs Passive Income: Learn the Difference & Why it Matters — Cultivating Cash

You want more money. And you know that to get more money, you need to increase your income. But you’re not sure what will get you there faster in a battle between active vs passive income.

This is why understanding the ins and outs of active and passive income is a game changer.

In this article, you will learn what passive and active income are, how they differ, and which to use to grow your wealth.

Let’s get into it.

Active income 101

Of the two types of income-active and passive-active income is the most well-known. So you may think you know all there is to know about it and skip right past this section.

But hold up.

Think of this section as a primer for understanding the next section and a means of inspiration-maybe you’ll find a mode of earning active income that you hadn’t thought of before!

What is active income?

Active income is the money you earn for physically giving your time to an employer or customer. The income you make is equivalent to time spent times the rate agreed upon between you and the other party.

When you get a paycheck from a full or part-time job or receive a cheque from a customer for a service you provide-that is active income. You provide your time and, in exchange, receive compensation for that time.

If you put in less time, you’ll earn less income.

And if you stop putting any effort in together? Well. You’ll earn no income at all.

Common types of active income include:

• A salary from a full-time job
• Wages earned from a part-time job
• Commissions earned on selling tangible or digital goods
• Fees earned providing services
• Tips made while engaged in any of the above.

We’ll take a closer look at each.

Common sources of active income

Salary: When you work for a company, and your compensation is based on an annual sum of money that your employer agrees to pay you over the year-you are earning a salary. Your income is consistent and unimpacted by whether you work more or fewer hours on any given day or week.

Wages: When you work for a company, and your compensation is based on hours worked, you earn wages. Your income will fluctuate from paycheck to paycheck based on how many hours you worked during the pay period.

Commissions: When you work for a company’s sales team, and a portion of your compensation is likely based on a percentage of the price of each good or service you sell-you are earning a commission. Your income will fluctuate based on your success in selling the product or service and the price tag of what the customer is purchasing.

Tips: When you work in the service industry (like a restaurant) and are directly involved with serving a customer, and a portion of your compensation is obtained through cash left by customers in excess of their bills-you are earning tips. Your income will fluctuate based on the quality of service you provide and the value of the customer’s bill.

Fees: When you work for yourself and are paid by a customer for a product or service you provide-you are earning fees. Your income will fluctuate based on your success in selling your product or service and how much you charge.

BONUS: You may also earn active income from…

• Cash or equity bonuses at work
• Flipping houses or furniture
• Performing in public areas
• Answering questions
• Product testing
• Reviewing books
• Taking on gig work,
• Working out
• Taking surveys
• Garage sales

…to name a few.

What does the IRS consider to be active income?

While it may seem obvious what counts as active income-activities that require your active involvement and time-income taxes complicate the matter.

So, to ensure you’re paying the appropriate taxes, it’s essential to consider how you earned your income against the IRS’s rules.

According to the IRS, your income is active if made in an activity that passes the “ material participation test.” Under the material participation test, income is active if earned via a means that passes one of the below tests during a tax year:

1. You worked more than 500 hours during the year.
2. Your effort constituted a substantial part of all participants in the business during the year.
3. You worked more than 100 hours during the year and participated in the activity at least as much as any other individual.
4. You participated in multiple activities for more than 100 hours each during the year, but your active participation in each activity, viewed in isolation, did not rise to the level of material participation. However, when combined, your time worked exceeded 500 hours.
5. You materially participated in the business for any 5 of the previous 10 years during which your efforts qualified for material participation in the activity by any of the other six tests.
6. You materially participated in the activity for any 3 of the previous 10 years, and the activity is a personal service activity (an activity that involves the taxpayer’s time and effort and in which capital is not a major income-producing factor).
7. You participated in the activity regularly, continuously, and substantially.

Again, the IRS considers your income active if your means of earning your income pass any of the above tests. Otherwise, it’s passive.

Passive income 101

Now that we’ve covered active income, we can explore the type of income that many believe to be elusive or only for the rich: passive income.

Hint: Those are myths!

What is passive income?

Passive income is the money you earn in the background, with little to no effort from yourself. The income you earn is equivalent to how often your offering is purchased or used times the rate you charge.

When you receive a dividend from investing in a company, earn royalties on a photograph you sell online, or sell an e-book-that is passive income. You provide your time (and/or money) to launch your product or acquire an investment and, in exchange, receive compensation with little to no effort from there on out.

You’ll make an income if you only work four hours a week.

And if you stop putting any effort in together? You’ll still rake in some money!

Common types of passive income include:

• Interest earned on savings or certificates of deposit
• Capital gains and dividends made on portfolio investments
• Rental Income
• Royalties

Let’s explore each.

Common sources of passive income

Interest: When you put your cash into a savings account, high-yield checking account, or certificate of deposit (aka a CD) and earn money for allowing the bank to use the cash to lend money to other customers-you are earning interest. Your income potential is impacted by how much cash you put into the bank account or CD, the interest rate offered by the bank, and how long you keep your money in the account.

Portfolio income: When you invest in stocks, bonds, and crowd-funded real estate and earn a return on your investment (a capital gain) or receive a portion of a company’s profits (a dividend)-you are earning portfolio income. Your income is impacted by how much and how long you invest in the asset and the volatility of an asset’s rate of return.

Rental income: When you own a rental property (whether residential or commercial real estate) and offer to third parties for occupancy-you are earning rental income. Your income is impacted by how much you charge for rent and whether the property is occupied.

Royalties: When you sell the rights to use an asset you developed and own (such as stock photography, music, and books) and receive a percentage of the revenues earned on said-you are earning royalties. Your income is impacted by how much you charge for and the sales generated by using the asset.

BONUS: You may also earn passive income from…

• Being a silent partner in a business
• Pensions
• Social security
• Affiliate marketing on a blog or social media
• Providing advertising space on a blog, website, or Youtube
• Print-on-demand
• Selling pre-recorded online courses
• Peer-to-peer lending
• Cash-back credit cards
• Renting out your parking space or any extra space in your home or garage for storage
• Allowing businesses to put advertisements on your car

…to name a few. You can really get creative here!

What does the IRS consider to be passive income?

As with active income, the IRS has specific guidelines for determining whether your income is passive.

According to the IRS, your income is passive if generated from:

• A business in which you don’t materially participate
• Rental activities

Note: For income tax purposes, portfolio income (capital gains and dividends earned on investments) is not considered passive income. As such, check out the IRS’s specific guidelines for earnings made through investments when filing your income tax return.

Active vs passive income: what’s the difference?

With the basics of active vs passive income under your belt, you can deepen and clarify your knowledge by looking at them side-by-side.

When doing so, consider the three main differentiators between active and passive income:

1. Effort required
2. Timing of payment
3. Taxes

Effort

Active Income: Ongoing effort. If you stop working, you stop earning.

Passive Income: Time and financial investments upfront, with minimal to no investments in the future.

Timing

Active Income: Consistent frequency. Payment quickly follows effort.

Passive Income: Unpredictable. Payment may occur years after effort/investment.

Taxes

Active Income: Subject to marginal income tax brackets (0%-37%). Subject to Social Security and Medicare taxes (15.3%, up to a certain level of income).

Passive Income: Highly variable based on the mode of earned income. May be eligible for certain deductions

Comparing the benefits of active vs passive income

Here’s the thing.

To earn passive income, you often need to invest money from active income to get started-or else to have an active income stream to support yourself until your passive income stream is up and running.

So basically, you need both.

And both have their pros and cons:

Pros

Active Income: Helps you to develop skills that can be used to generate passive income down the road. Offers social and networking opportunities.

Passive Income: Little to no effort is required. More time to live your ideal lifestyle. Lower tax rates. Scalable as few ongoing resources are required. Allows you to be location agnostic.

Cons

Active Income: Requires significant investments in your time. May restrict where you can live. Subject to steep income taxes. Difficult to scale-you only have so much time! Vulnerable to layoffs.

Passive Income: Often requires significant cash or time investments upfront. Requires patience. Vulnerable to the market and changes in consumer demand

That said, passive income is king at the end of the day because, well, who doesn’t want to get paid while you sleep?

Active vs passive income: utilize both!

The means of making a living are infinite, but the types of income are limited to two: passive and active.

• Active income = Money earned in exchange for ongoing time and participation
• Passive income = Money earned tomorrow based on time and financial investments made today.

Subscribe today to receive guides to earning both.

Originally published at https://cultivatingcash.com on December 13, 2022 (https://cultivatingcash.com/2022/12/12/active-vs-passive-income/).