Uncover the distinction between active income and passive income, delving into earned income’s hands-on nature and the hands-off, continuous earnings of passive income. Explore how passive income sources, like investments or online ventures, offer financial freedom. Learn the principles of generating passive income, discover various streams, and understand the symbiotic relationship between active and passive income in achieving long-term financial stability.
Regardless of the avenue you choose to earn your livelihood, the income you generate can be categorized into either passive income or active income. While these terms might sound familiar, their nuances often remain unclear to many individuals.
In essence, income can be broadly classified into three main types: Earned, portfolio, and passive.
1. Earned Income or Active Income
Active income pertains to the earnings derived from providing a service or performing a specific job function.
Also known as earned income, it encompasses the money acquired through full-time employment or running a business. This category excludes rental income from real estate and includes wages, salaries, tips, and commissions. Notably, active income is subject to higher taxation due to its direct association with labor.
Active income involves trading time for monetary compensation. For instance, an individual working as a web designer receives a predetermined sum in exchange for the time and effort invested in their work. Typically, earned income is adequate to cover essential monthly expenses, leaving limited room for investment.
2. Passive Income
Imagine being able to invest effort upfront in something that generates income continuously for years. This is the essence of passive income.
Passive income is money derived from previous investments or actions, continuing to yield profits without requiring ongoing engagement.
It encompasses earnings from rental properties, patent royalties, interest from bank deposits, and profits stemming from limited partnerships. Passive income operates as an asset, generating revenue irrespective of active involvement.
In this scenario, revenue is typically earned regularly with minimal or no additional effort. Passive income incurs lower taxation compared to both earned and portfolio income.
3. Portfolio Income (Subset of Passive Income)
Portfolio income pertains to gains resulting from capital investments. This includes income from dividends on shares, interest, and capital gains derived from stock sales.
For instance, an individual purchasing company stock at a certain price anticipates selling it at a higher value in the future. If the stock bought at $100 appreciates to $400 when sold, the capital gain amounts to $300, representing their profit. This profit is a result of investing in undervalued stocks with the expectation of capitalizing on price appreciation.
Key Takeaway: Portfolio income falls within the realm of passive income. It underscores the gains achievable through strategic investments in stocks, dividends, and capital appreciation.
How is active income different from passive income?
| Active income | Passive income |
| You are doing something (some work, devoting time, energy, or effort) in order to receive that income. | You are earning a regular source of income with little to no effort required to keep it coming. |
| Income received from performing a service or from a business in which there is material participation | Income from a business in which the taxpayer does not materially participate |
| Does not lead to financial freedom; the hustle to work never stops | This leads to financial freedom; eventually generates more idle time |
| Sources can be:
– Salary, wages, commissions, and tips – An active business in which the majority of the work is done by the taxpayer |
Sources can be:
– Rental properties (collecting rent from tenants) – Limited partnership, or other enterprises in which a person is not actively involved – Dividends on stocks and interest on loans – Peer-to-peer lending (P2P) – Capital gains |
| – Typically carries a lower risk
– When you are participating in an activity to derive income, the risk exposure is minimum |
– May involve a relatively higher risk
– Risking capital to try to earn passive income |
| – Active income is more predictable
– Makes it easy to plan a monthly budget |
– It may be comparatively unpredictable |
| – May make individuals complacent and/or risk-averse | Individuals believe in risk-taking and discovering new opportunities |
| – Can limit earning potential | Does not limit earning potential |
From Job Dependency to Passion Dependency
Rich people (with strong passive income) can still work for money, but they have virtually zero dependencies on their job/employment earnings. They are financially independent. And if they stop doing jobs, their passive earnings will take care of all life’s needs. Financial independence is that stage of life where you are no more dependent on your job to manage your needs of life. But attaining financial independence through a job has a low success rate.
Most people fail to enjoy financial independence since they don’t leave the clutches of their job. It takes time to build an income that replaces your job income or becomes a job replacer.
Nevertheless, everyone can take steps to move from job dependency to passion dependency.
For example, to generate $100 from a job, you put in 100% effort. Say if you follow your passion that generates an equal income of $100, the difference would be that you shall have to put in less effort as you relish your passion. It could be 20-30% effort for generating $100.
Earnings are capped no matter how hard one works as the salary is fixed. This means if you get $40,000 a month, you shall still get $40,000 irrespective of the amount of effort that you put in. However, if you work towards your passion, there is no limit to your earnings and it can be envisaged as you are generating income by doing nothing.
To sum up, passive income entails the following principles:
- Earn money from your passion
- Invest part of that income into buying assets
- Such assets generate passive income
- Identifying quality asset
- Buying them at an undervalued price
- Keep accumulating such assets all life
These days, there are a plethora of options available to generate passive income. Some examples to earn passive income from multiple streams of revenue can be:
Blogging: Most of the blogs employ Google AdSense, which offers a monthly revenue stream based on ads that Google places on the site.
Affiliate marketing: Website owners, social media influencers, or bloggers promote a third party’s product by including a link to the product on their site or social media account, in exchange for a commission. The most well-known affiliate partners are Amazon, eBay, Awin and ShareASale, etc.
Freelance Business: Leverage your skills by freelancing on platforms like PeoplePerHour, Upwork, and Project4Hire. Your passion can find a market here, whether it’s artwork or specialized services. By showcasing your work on crowdsourcing sites and creating a compelling profile, you can tap into a potential stream of income.
YouTube Channel: Create a YouTube channel and enjoy passive income as long as your videos continue to draw viewership. Once a video is posted, it generates income over time. With a growing library and increasing views, your income potential escalates, making YouTube a viable source of passive earnings.
Dividends from Stocks: Dabble in passive income through equity investment by selecting dividend-paying stocks or ETFs. As a shareholder in companies offering dividend-yielding stocks, you receive periodic payments. Companies often distribute cash dividends quarterly from their profits, offering you a consistent flow of passive income.
Others: The list is endless. However, some other options are investing in rental properties; investing in money market funds and mutual funds; investing in a high-yield certificate of deposit; becoming a silent business partner; listing your property on any number of websites such as Airbnb, and fixing the rental terms; investing in bonds or debentures; self-publishing on Amazon; creating an App; distributing, promoting and selling online courses through websites like Udemy, Skillshare, and Coursera; building an e-commerce store, etc.
Deciding between active and passive income – What really matters?
The significance of passive income cannot be overstated, as it grants you the ability to earn without constant physical involvement. Having a passive income stream means money flows in round the clock, every day of the year. This potential to sustain your lifestyle over the long haul makes passive income an essential pursuit.
Nonetheless, it’s important to recognize that building passive income is a gradual process, often spanning years. Whether you’re investing, cultivating an online audience through a blog, or amassing funds for property purchase, substantial initial effort—active engagement—is required to establish a passive income foundation.
Concurrently, active income holds its own importance by ensuring swift and consistent earnings. In most cases, passive income isn’t viable without a prior phase of active income generation. True, active income doesn’t continue while you sleep, yet it financially supports your endeavors to construct passive income over time.
In the dynamic interplay of active and passive income, the key lies in understanding their symbiotic relationship. While active income lays the groundwork, passive income serves as the long-term sustainer, offering financial freedom and stability.
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