Definition
Passive income refers to earnings derived from a rental property, limited partnership, or other enterprise in which a person is not actively involved. This can also include earnings from investments, real estate, royalties or online business. In contrast, active income is the income for which services have been performed, and includes salary, wages, tips, commissions, and income from businesses where one materially participates.
Key Takeaways
- Passive income is the revenue generated without active involvement or, in other words, earnings from a rental property, limited partnership, or other enterprise in which a person is not actively involved. It requires an initial effort to set up the income stream, then it runs on autopilot with minimal maintenance.
- Active income, on the other hand, is income that requires active work or services performed. This includes wages, tips, salaries, commissions, and income from businesses in which there is material participation. It is directly tied to your time and efforts.
- While both passive and active income can contribute to your wealth, a balance between both can often be beneficial. Passive income can provide you with enhanced financial security and the opportunity to earn money while you sleep, whereas active income gives you more direct control over your income level based on the amount of work you put in.
Importance
The finance terms Passive Income and Active Income are important because they define two different methods of generating income that can significantly impact an individual’s financial strategy and tax situation.
Active income typically refers to income earned through direct involvement in a job or business, such as wages, salaries, tips, or profits from a business you actively manage.
On the other hand, passive income refers to income generated with minimal to no direct involvement, such as earnings from rental properties, royalties, investments, or businesses where you’re not actively involved.
Understanding the difference is crucial as they each come with their own tax implications and require different strategies to effectively increase your wealth.
While active income can provide immediate economic security, passive income can lead to long-term financial growth and freedom, offering an income source with less time commitment.
Explanation
Passive income and active income are both vital concepts in personal finance and wealth generation, but they serve different purposes. Active income refers to revenue generated through direct action, often via a job or business where you’re actively working. It is used as a primary source of livelihood.
For the most part, people rely on active income to cover their daily expenses, such as paying bills, buying groceries or maintaining lifestyle. By dedicating your time and effort toward performing a service or creating a product, you are actively contributing to this income stream. Meanwhile, the purpose of passive income is to provide an ongoing source of revenue with minimal daily effort, allowing individuals to build wealth over time and potentially achieve financial freedom.
This income comes from sources where an individual is not actively involved, which might include rental income from properties, returns or interest received from stocks, bonds, or mutual funds, royalties from books or music, or income from online advertisements or affiliate marketing. Passive income provides financial security because this income stream is generated even when you’re not actively working, serving as a safety net if there are interruptions in active income. The primary use of passive income is to supplement active income and contribute to overall wealth accumulation.
Examples of Passive Income vs Active Income
Rental Property: This is an example of passive income. If a person purchases a property not for their personal use but to rent it out to others, the rental income they would receive each month is considered passive income. This is because they are earning money regularly without actively working on a day-to-day basis. They might invest time and money in property maintenance and dealing with tenants from time to time but the income doesn’t typically require daily effort.
Full-Time Job: This is an example of active income. When a person works 40 hours a week as an employee in an organization, the paycheck that they receive is considered active income. This is income that directly corresponds to the amount of time and effort put in daily. If the person does not work, they don’t receive a paycheck.
Owning a Business: This can illustrate both types of income. If a person starts a restaurant, in the early stages, they will likely be involved in day-to-day operations such as managing staff, ordering supplies, or even cooking. The income from the restaurant during this stage is active, as it involves a active participation. However, once the restaurant is established and the person hires a manager to run the place, any profit that comes to the owner is passive income because they are not actively involved in its day-to-day operations.
Frequently Asked Questions: Passive Income vs Active Income
What is the difference between passive income and active income?
Active income is income that is earned in exchange for performing a service. This includes salaries, wages, tips, and income from businesses in which there is material participation. Conversely, passive income is income that requires little to no effort to earn and maintain. This includes earnings from rental properties, limited partnership, and businesses in which the individual does not materially participate.
What are some examples of passive income?
Examples of passive income include earnings from stock dividends, real estate rentals, royalties from books or music, and income generated from internet advertisements on websites.You can also earn passive income from peer-to-peer lending, creating an online course, or monetizing a YouTube channel.
What are some examples of active income?
Active income typically includes wages, salaries, tips, and any money made from a job or a business where you actively participate. For example, if you own and operate a bakery where you bake and sell bread, your earnings from this enterprise would be considered active income.
Is one type of income better than the other?
Neither type of income is inherently better or worse than the other. It largely depends on an individual’s financial goals, time commitments, and personal preference. Some people prefer the stability of active income, while others prefer the prospect of earning money with minimal ongoing effort that comes with passive income.
Related Entrepreneurship Terms
- Residual Income
- Dividend and Interest Income
- Capital Gains
- Retirement Accounts
- Peer-to-peer Lending
Rental Property Income
Sources for More Information
- Investopedia – It’s an educational website focusing on investing and finance, and it helps in understanding financial concepts, improving investing skills, and learning how to manage money.
- The Motley Fool – It provides top insights and analysis about stocks, helping millions of people attain financial freedom through their website, podcasts, books, newspaper column, radio show, and premium investing services.
- My Money Coach – A free public service provided by the Credit Counselling Society (CCS). The site is a comprehensive resource that can help you make wise financial decisions.
- Financial Samurai – A top personal finance blog. Since 2009, Financial Samurai has been teaching everyone how to slice through money’s mysteries.
