Once you start earning, you will come across two types of income which you may or may not recognize at an instant. They are active and passive incomes.
A blend of both can ensure you have a fulfilling financial life, and having both helps you achieve your monetary goals faster. Let’s look into more detail about each one of them.
What is Active Income?
In simple words – it is the income you get for providing a service of any form. This could be in the form of commissions, salaries, tips or wages. Consider active income as paying you for being a participant in any form of business.
The most common form of active income is the paycheck you receive from your employer. Almost all the countries that have income tax, do put a tax on active income.
What is Passive Income?
Consider any form of business or work in which you are not actively involved, and yet earning from it, that is your passive income. For example, if you are a partner in a company or have your own house that you have given rent to, the income you get from these is your passive income. Note that most countries count passive income as taxable.
The more passive income components you have, the greater is your financial stability. It gives you the freedom to make choices and also acts as a cushion if your active income subsides or cuts for some reason.
Here are some types of passive income you must know:
- Interest that is Self-Charged: If money is provided as a loan to a partnership or an S-Corporation, the interest you earn from that loan acts as a passive income.
- Rents: Unless you are a real estate professional, the money you earn from rents of your houses or apartments counts as passive. Note that, if you own a space and are renting it out to a business or a corporation, it may or may not be counted as a passive income, depending on the country you are in and if it is signed as a lease or not.
- Participation in a Business As an Investor: If you have put money in a business and have made a deal to earn a percentage of the earnings from the owners without being a part of the business in an active form, it counts towards your passive income. On the other hand, if you provide material participation in managing the company, then you are treating it as your active income.
To understand this simply, the IRS (Internal Revenue Service) counts more than 500 hours dedicated to an activity or business as a material participation. Also, if your participation has been substantial throughout a financial year, then also it is considered material participation.
Depending on whether this falls as your active or passive income, you may be taxed differently based on the country you reside in.
Active Income vs Passive Income: The Difference
|Active Income||Passive Income|
|Income derived from the direct effort you put into any business or organization||Income derived with minimal or no effort|
|Examples include: salaries, wages and employer paychecks||Examples include: Apartments / house rents, stocks dividends, interests on loans|
|The way to earn active income is typically straightforward – gain education and land a job||The way to earn passive income is complex, and typically takes years to build and in some cases, prior investments as well|
|Ideal split for beginner hustlers – 75% of income must be active||Ideal split for beginner hustlers – 25% of income must be passive|
True financial growth is when you have a balance of active and passive income. If you are still in your 20s, it is recommended to start thinking of generating passive income for you when you reach your 40s and late 50s.
That will help you with your retirement as well. As far as your active income is concerned, make sure you are in a job that pays you appropriately well for the work you are doing. This way, you will continually stay motivated. All the best for reaching your financial goals!