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If you're not quite sure of the difference between active, passive, and portfolio income, this article is for you.
It’ll help you understand what makes each one distinct and provide insight into which income source or sources to target.
Active, Passive, & Portfolio Income Explained
The main distinctions between these three types of income are how you earn your money and how those earnings are taxed.
Active Income aka Earned Income
When you perform a service for payment in the form of salary, wages, commissions, or tips, you're earning active income. You're either an employee or self-employed and time quite literally equals money.
If Diane clocks in at the office from nine in the morning to five, her employers pay for her time and effort. This means that her paycheck counts as an active income.
The same goes for Sandy, the realtor, Stacy, the food service worker, and Michelle, the bank manager.
They all actively work for a profit, paid as a direct return on their performance of job responsibilities.
Regular compensation is one nice perk of active income. You might also be rewarded for your work efforts with a benefits package to go along with it.
The downside is that these kinds of occupations may leave people feeling burned out and stuck with limits of earning only as much as you can by exchanging time for money.
When you collect income from a business venture in which you’re not actively involved, you're passively earning income.
You can also earn money passively as rental income, as interest on savings accounts, certificates of deposit and municipal bonds, or winnings from a lottery, for example.
Passive income is money you regularly receive without performing active work. Or it can be income such as a pension or book royalties you receive sometime after active work was conducted.
Most people find earning income from passive activities appealing because it seems like less effort.
You might also be able to sell a business or investment later for a nice payout. Or you can continue collecting passive cash flow to help pay your expenses and invest it further to earn even more.
If you're a creator or thought leader, you might consider writing and selling an income-producing asset like an e-book or online course. Yet this isn’t passive income initially.
But it can eventually generate revenue that surpasses the value of your initial time investment and continue bringing in further passive earnings for years.
While passive income may call for less effort overall, its main downside is risk. And to make a substantial income, you'll likely have to invest a lot in advance.
That can mean a large financial investment, a time investment when you’re willing to do some unpaid work upfront for a chance at passive income later, or some combination of both.
An online course may require minimal cash to set up, but you'll likely spend considerable time preparing and organizing the content, marketing the course, and providing customer service.
Another example is buying rental income properties. Rental activity can be mostly passive for one investor who hires a property manager and predominantly active for another who manages the rentals herself as a real estate professional. (Special rules and exceptions apply to real estate activities.)
What is Portfolio Income?
When you invest for your retirement or other long-term goals, you might consider purchasing: stocks, mutual funds, exchange-traded funds (ETFs), a real estate investment trust (REIT), or other investments that don't require you to actively perform work to earn money.
Any qualified dividend income, interest, or capital gains you earn from these investments are considered portfolio or investment income. While investment income is often considered passive income, there may be a difference in how they're taxed.
Portfolio income is not subject to Medicare or social security taxes, and portfolio losses can offset capital gains.
Which Categories of Income to Focus On
Depending on your lifestyle, you might either prefer the security of active income or the freedom passive income earning seems to provide.
But regardless of your preferences, one might be more realistic for you than the other right now.
For example, Stacy might marvel at the idea of leaving her current job in pursuit of passive income. She'd be able to spend more time with her family and enjoy more of life.
However, she hasn't saved a penny of her paychecks in the five years she's been employed. She has no financial capital to invest, and she doesn't have the time nor expertise to create a profitable asset to sell.
Her active income job is more realistic right now, but that doesn't mean she's stuck there.
It merely means she needs to use this as inspiration to plan her finances better, save money, and invest time in developing expertise in a profitable niche.
That said, is it more realistic for you to focus on passive or nonpassive income? It all depends on your priorities.
Do you have family or dependents to support with your income?
Do you have outstanding debt?
If so, then a reliable type of income needs to remain a priority for you.
While that may sound simple enough, it comes with a disadvantage. Your income will only flow as long as you put in the work for it. If you’re not actively working, you’re not earning.
Also, while reliable income doesn't automatically mean you need a 9 to 5, it’s wise to make sure that any income stream you pursue is predictable and lucrative.
A passive income could be reliable, but a lack of preparation can cause devastating financial drawbacks. Until you have enough money or time to lay the groundwork for passive income, stick with the reliable income source.
Once you have an adequate emergency fund and at least your high-interest debt eliminated, you can consider investing your discretionary active income in creating streams of passive income.
Another priority that many people value is wealth-building or the process of amassing financial capital and long-term income from investments.
Are there any opportunities for upward mobility on the career ladder at work? Do you see options to scale your solo business?
If you're a freelancer who wants to build her wealth, turn some of your efforts towards doing more than offering services.
Some next steps to consider are:
- Selling profitable assets
- Growing your client base
- Outsourcing gigs
- Starting an agency
If you don't see a way to scale your freelance business, that's okay! Instead, you could create an EBook or online course and use your client testimonials as social proof of your expertise.
The last factor to consider is whether you're willing (and able) to make the initial investment.
Are you willing to put forth a lump sum of money or time today in exchange for long-term income tomorrow, which doesn't come with a guarantee?
Be sure you have a solid financial foundation established before investing money.
Do you have more time than money to invest right now?
Just remember, while a time investment might be all you need to kick things off, you're not making any less of a commitment than someone who invests money.
Earning an income from books or courses comparable to income generated from investing in real estate rentals for passive income could take months (maybe years) of work upfront.
How Forms of Income are Taxed
An important component in choosing between income approaches is taxing methods. You'll be taxed differently, contingent on your source of income.
As mentioned earlier, any income you earn through services or material participation in a company or business is considered active.
For clarification, here are the Internal Revenue Service's (IRS's) definitions for material participation:
- You work 500 or more hours per year for a business
- You do the majority of the work for a business
- You work more than 100 hours per year for a business, and no staff works more hours than you
Note that although selling digital assets online might be considered a passive income stream (which can be lucrative), it's technically a service your business provides, and therefore ordinary income.
With active income, your taxable income is either from being an employee or a self-employed individual.
Employees, or people who are material participants of someone else's business pay income taxes plus the employee half of Social Security and Medicare employment taxes.
You're probably already familiar with income tax rates, but the Tax Cuts and Jobs Act shifted them, so make sure that you're still in the taxable income bracket you think you are.
|Rate||Single||Married-Joint||Head of |
|10%||$0 – $9,950||$0 – $19,900||$0 – $14,200|
|12%||$9,951 – $40,525||$19,901 – $81,050||$14,201 – $54,200|
|22%||$40,526 – $86,375||$81,051 – $172,750||$54,201 – $86,350|
|24%||$86,376 – $164,925||$172,751 – $329,850||$86,351 – 164,900|
|32%||$164,926 – $209,425||$329,851 – $418,850||$164,901 – $209,400|
|35%||$209,426 – $523,600||$418,851 – $628,300||$209,401 – $523,600|
|37%||More than $523,600||More than $628,300||More than $523,600|
On the other hand, self-employed individuals — people who earn income through independent ventures like freelancing — face self-employment taxes on top of their income tax.
In short, the self-employment tax is the sum of Social Security (12.4%) and Medicare (2.9%). Instead of your employer paying a portion, you pay all the tax yourself.
This particular tax only affects your net earnings or profits. Like any other business, you can write off most expenses involved in providing the services that earn your income.
In contrast, earning income without material participation is considered a passive activity by the IRS. Some examples include:
- Property investments
- Dividend stocks
- Limited partnerships
This income is taxed by category — short-term or long-term.
Short-term investments are assets you've only held onto for a year or less. “Capital gains” refer to the profits you earn from selling an investment or property, and they are taxed at the same rates as income tax.
Long-term investments, on the other hand, refer to assets you keep for over a year and are taxed at a long-term capital gain rate. You'll pay a long-term capital gains tax rate of 0%, 15%, and 20%, dependent on your income and filing status.
If you file “single” and report less than a $39,375 profit from long-term investments, you'll pay $0 in taxes that year.
Now, this can change, as policies often change with the administration. But it's clear that holding onto your investments for a longer period of time can usually be better from a tax perspective. And it never hurts to seek professional advice when it comes to investments and taxes.
Partnering with a trusted financial advisor and tax professional can help you with your earning and investment decisions to maximize income and tax deductions, and limit tax liability.
Finding The Right Income Balance
Is it possible to have lucrative active and passive income streams? What does it look like to have both?
90% active income
Almost all of your gross income comes from an active role in a business or company.
Despite offering financial security, this regular income arrangement can feel constricting, as you have very little power over your financial growth and future.
60% active income
The major percentage of earnings is from a full-time job or self-employment income. But with the implementation of a few passive income ideas, you're getting a taste of freedom from the additional stream(s) of income they provide.
50/50 active and passive income
Your upfront investments are beginning to pay off, and the excitement is setting in.
You receive half of your income through a reliable source, such as your part-time corporate job position. You've also invested in a couple of rental properties using property management and receive significant cash flow from renters every month.
This is the sweet spot for anyone working on building wealth and supporting a family. There's income you can depend on, and you’re building equity in those properties for financial freedom.
90% passive income
Once you're here, the active form of income is essentially a fun hobby. You pay bills with income from dividends and other passive investments and activities.
You’re excited to go to work 10% of the time and do what you want the other 90%.
However, this is also where your income is least reliable. Your financial survival almost entirely hinges on investments, which can either pay off or…not.
The key is to figure out where you feel most comfortable financially and go from there.
Before making any income or investment decision, spend time considering your long-term financial goals. Then with some strategic financial planning, you can develop your income and investment strategy to achieve your definition of financial freedom.
That might include buying individual stocks or ETFs in the stock market, securing government or corporate bonds, building a sizeable real estate portfolio, or developing and selling digital courses. Or all the above.
Consider the upfront investment of time and money to achieve the right balance of the various sources of income as you make each financial decision when building your investment portfolio.
Article written by Lyric