Active vs. Passive Income: Which Is Best for You?

Active income is income you earn through working a job or performing a task. Passive income is income that doesn’t come from an employer or work contract. Even though it’s “passive” income, you may still need to work hard to set up those income streams.

Which type of income is best? For many, a combination of both makes sense. Let’s look at passive versus active income so you can decide how to best set yourself up for financial stability.

What is active income?

Also known as earned income, active income is income from a part-time or full-time job or from performing a task or service such as cleaning a home or designing a website.

Active income allows you to earn an income quickly and consistently. Let's walk through a list of active income options:

Salary

Salary is a type of active income that refers to fixed compensation for regular services. If you’re paid a salary, you typically receive the same pay each pay period, and you’re not usually eligible for overtime.

Hourly wages

An hourly wage means you earn money per hour at your job, whether you deliver newspapers or work as a phlebotomist. When you work an hourly job and work more than 40 hours per week, you may be entitled to overtime pay, which pays more than your regular hourly pay.

Commissions

If you're a commission-based employee, you earn money based on how much you sell. Companies use different variables to determine commissions. For example, you might be paid a percentage of what the customer pays for a product. You may also receive pay based on performance factors, such as earning a bonus for hitting a certain amount of sales. Commission-based jobs can include sales, recruiting, finance, and real estate.

Consulting and freelance services

You can make active income as a self-employed consultant or freelancer. If you have a skill set that helps people and businesses achieve their goals, you could offer those services. For example, if you are an excellent salesperson, you could help other people boost their businesses' sales as a consultant.

What is passive income?

Passive income (also sometimes called residual income) is income from a source other than an employer or contract. When you want to earn passive income, you have to work to set up your income stream upfront, but then you can generate money from those initial efforts. It gives you ongoing cash flow without demanding as much of your time.

Passive income can include income from investments, properties you own, or side hustles that don't require a lot of work to maintain. Let's walk through a few examples of passive income.

Real estate

You can take several approaches to real estate investing, but owning and renting out real estate is a popular way to earn passive income.

Of course, it takes a significant initial investment to buy a rental property. And sometimes you have to renovate a rental property before renting it out, which means you might not earn rental income right away. And you’ll need to maintain your properties and take the time to find and screen potential tenants.

Online income

You can find many options for making a passive income stream online:

• Affiliate income: Affiliate marketing happens when an online retailer pays you a commission for traffic or sales that happen from your referrals. You typically need to run a website or use social media to earn your affiliate income.
• Ads on a blog or video: Another way to earn passive income as a blogger or YouTuber is to put actual ads directly on your blog or YouTube channel. You earn money when people click on the ads in your copy or clips.
• Creating and selling products: Creating a course or product, selling photography online, or selling another type of product could help you make passive money online.
• Peer-to-peer lending: Peer-to-peer lending, also called “social” or “crowd” lending, is a type of financing that allows you to loan money to people or businesses. As borrowers make their loan payments, a portion of the payment (interest and principal) goes to you and other investors.
• Royalties: You earn royalties when someone pays you money for the use of your intellectual property. For example, if you produce copyrighted music and someone else wants to use it, they pay you money to do so.

Investment portfolios

Investing money is another form of passive income. If you’re considering how to invest money for a passive income, one option is buying dividend stocks. These stocks have a history of paying shareholders a portion of company profits, which you could cash out or use to buy more stock.

You could also invest in mutual funds, exchange-traded funds (ETFs), and index funds instead of individual stocks. Let's walk through these options as well:

• Mutual funds: These are bundles of securities purchased with funds from a pool of investors. For example, you might decide to invest in a mutual fund that focuses on tech stocks.
• Exchange-traded funds (ETFs): ETFs are baskets of securities that track an index, sector, commodity, or another asset that are purchased or sold on the stock market.
• Index funds: Index funds seek to track the returns of a market index. For example, index funds may track the S&P 500, the most popular large index to track.
• Bonds: These may offer interest income, but the interest rate is often low.

To get started with any of these, you’ll need a brokerage account. If you’re a beginner with investing, take your time to explore your options and decide which ones fit your risk tolerance, interests, and investment goals.

How passive income is taxed

Income earned from passive activities is taxable, just like a full-time job. You are responsible for income taxes on any earnings. The amount of tax you owe depends on certain factors, including the amount you earn and whether you actively participate in the business generating income (called “material participation” by the IRS).

For example, if you own an ice cream shop and are a silent partner, that could be passive income. If you actively manage the shop, that likely won’t be considered passive income by the IRS. It would likely be considered a business and taxed accordingly.

Additionally, income from an investment portfolio isn’t considered passive income by the IRS. It’s considered portfolio income, and it could be subject to short-term or long-term capital gains taxes. If that sounds confusing (and it is), consider connecting with a tax professional such as a certified public accountant (CPA) to learn more about how much you'll pay on your passive income endeavors.

FAQs

Bottom line

Think you're interested in ways to earn passive income? Start by thinking about your talents and qualifications and use that to determine which passive income ideas might work best for you. Then start laying the groundwork.