Passive vs Active Income: Know the Difference and Why You Want Both?

Key Points

  • Active income is trading dollars for hours, while passive income is money earned from investments.
  • Active income generally involves paying both payroll and ordinary income taxes.
  • Passive income can come with lower tax rates, but losses are subject to passive loss limitation rules.
  • Material participation in the business determines whether the income is passive or active.
  • The structure of your business can determine the type of income you receive.

Table of Contents

  1. What is Active Income?
  2. What is Passive Income?
  3. Active vs Passive Income: Main Differences
  4. What are the Advantages of Passive Income and Active Income?
  5. What are the Risks of Passive Income and Active Income
  6. What About Owning a Business?
  7. Passive Activity Loss Limitations
  8. Conclusion

By now, we’ve all heard finance gurus talking about reaching financial freedom with passive income. What really is passive income? How do you generate passive income, and how is it taxed? These are a few of the questions that might be floating around in your head.

At the most basic level, active income is money you work for, while passive income is earned without doing anything. Understanding the different types of income streams can help you minimize your taxes, plan for the future, and reach your financial goals.

In this article, we’ll explore the similarities and differences between active and passive income, outlining examples and discussing the advantages of generating hands-off income.

1. What is Active Income?

Active income is money earned through trading your hours for dollars. There is a direct involvement in the money you are earning, whether that be providing services or products. Most jobs that work for a traditional employer qualify as active income. Active income doesn’t always come in the form of a fixed salary. Here are the types of active income:

  • Salaries and Wages – This is the most common type of active income, where you receive regular payments. These payments can either be based on an hourly rate or a salary. Salaries and wages involve direct time invested in work-related activities.
  • Self-Employment – If you run a small business, you are also generating active income. Consulting, freelance work, and making goods are all forms of active income. Instead of an organization paying your wages, you are generating your own income, trading hours for dollars.
  • Commissions and Bonuses – Any type of extra compensation, like commissions and bonuses, are also active income. Working as a salesman or receiving a year-end bonus will be categorized as active income. 

Active income will generally be reported on Form W-2 or Form 1099-NEC each year.

2. What is Passive Income?

Passive income is money that is automatically generated without any work on your part. Passive income is commonly earned in the form of investments, like receiving interest income on your savings account balance or dividend income from a stock you hold. You will generally need to supply upfront capital to generate passive income, like purchasing the stock or putting the money in savings. Here are some of the other types of passive income:

  • Rental Income – Many landlords generate passive rental income, as there are minimal duties outside of supplying the initial capital to purchase the property. However, there are certain situations where rental income might be considered active. If you work as a real estate professional in your day job or you are renting your property to a company where you conduct business, your rental income might be active income.
  • Royalties – Royalties are income earned from others using your creative or intellectual property. For example, a commercial playing your song or a company using your invention. Money received in the form of royalties is usually passive income.
  • Capital Gains – Capital gains occur when you receive proceeds from an asset sale over your cost basis. Let’s say you buy an investment property for $200,000 and sell it for $300,000. You would generate $100,000 of capital gains, which is classified as passive income.
  • Interest and Dividends – Money received from investments in the stock market, savings, and public companies generate passive income. You will receive a Form 1099 that outlines your earnings for the year.

If you invest money in a “set it and forget it” type of investment, it’s usually considered passive.

3. Active vs Passive Income: Main Differences

While both passive and active income streams can contribute to your finances, it’s important to understand the tax differences. Active income is often taxed at higher ordinary tax rates. In addition, if you are self-employed or a member of a partnership, you will end up paying both the employee and employer’s portion of employment taxes, like Social Security and Medicare. Depending on the type of business, you and your CPA may want to look into a different entity structure, like an S-Corporation, to mitigate some of these taxes. On the contrary, passive income isn’t subject to self-employment taxes.

Moreover, passive income opens the door to favorable tax rates, such as long-term capital gains. Long-term capital gains rates go into effect when you hold an investment for over one year before you sell it—for example, buying a stock in January 2023 and selling it in June 2024. Long-term capital gains rates can range from 0% to 20%, which can be much lower compared to the ordinary tax rates ranging from 10% to 37%.

4. What are the Advantages of Passive Income and Active Income?

Passive income and active income are two distinct ways of earning money, each with its own set of advantages. Here’s an overview of the advantages of passive income compared to active income:

Passive Income

  • Time Freedom: Passive income streams often require an upfront investment of time, money, or effort. Once those are set, they can generate income with minimal ongoing involvement, allowing you to have more time for other pursuits.
  • Scalability: Many passive income sources can be scaled without a proportional increase in time or effort. For example, if you’re earning passive income from investments or a successful online business, you can potentially increase your earnings without working more hours.
  • Reduced Stress: Passive income can provide a state of financial security and stability. Since it continues to flow in even when you’re not actively working, it can help reduce the stress associated with the unpredictability of active income.
  • Diversification: Passive income allows you to diversify your income streams. Relying solely on a salary or wages from a job exposes you to the risk of job loss, so diversifying with passive income sources can provide a safety net
  • Financial Independence: Accumulating passive income can contribute significantly to achieving financial independence. It can give you the flexibility to make choices based on your preferences rather than being solely dictated by financial necessity.

Active Income

  • Immediate Rewards: Active income, often associated with traditional employment or freelance work, provides immediate and predictable rewards. You receive a paycheck or payment for services rendered on a regular basis.
  • Skill Development: Active income often involves direct participation and effort, allowing for skill development and career advancement. As you actively work, you can enhance your expertise and potentially increase your earning potential.
  • Job Security: Many active income sources come with a degree of job security, especially in traditional employment. A regular paycheck can offer a sense of stability and certainty.
  • Career Progression: Active income is often tied to career progression. Advancements, promotions, and salary increases are more common in active income scenarios, providing opportunities for professional growth.
  • Control and Influence: In active income pursuits, you have more direct control over your earnings and the direction of your career. Your efforts directly contribute to your income level, giving you a sense of control.

The ideal financial strategy often involves a combination of both passive and active income sources. Balancing both can create a more resilient and diversified financial portfolio.

5. What are the Risks of Passive Income and Active Income

Both passive income and active income come with their own set of risks. Understanding these risks is essential for making informed decisions about your financial strategy. Here’s an overview of the risks associated with each:

Passive Income

  • Initial Investment Risk: Many passive income streams require an upfront investment, whether it’s in the form of money, time, or effort. There’s a risk that the initial investment may not yield the expected returns, and it might take time to recoup or start generating profits.
  • Market Volatility: Passive income sources tied to investments, such as stocks, real estate, or businesses, can be influenced by market fluctuations. Economic downturns, shifts in consumer behavior, or changes in market conditions can impact passive income negatively.
  • Dependency on External Factors: Passive income often depends on external factors that you may not have control over. For example, rental income can be affected by the real estate market, and dividends from stocks can be influenced by the performance of the companies in your portfolio.
  • Lack of Immediate Control: With passive income, there’s typically less direct control over day-to-day operations. If the management of your passive income source is lacking, it can affect your returns, and addressing issues may take time.
  • Regulatory Changes: Changes in tax laws or regulations can impact passive income sources. For instance, alterations in tax policies related to investments or rental properties may affect the overall profitability of these ventures.

Active Income

  • Job Insecurity: Active income, especially in traditional employment, comes with the risk of job loss. Economic downturns, company restructuring, or changes in industry trends can lead to job insecurity.
  • Limited Time for Personal Pursuits: Active income often requires ongoing time and effort, potentially leading to a work-life imbalance. The risk is that you might have limited time for personal and family activities.
  • Market Demand: In certain fields, the demand for your skills or services may fluctuate based on market trends. Staying relevant and adapting to changes in your industry is crucial to mitigating this risk.
  • Health and Burnout: The pursuit of active income can sometimes lead to health-related issues and burnout. Long working hours, stress, and intense workloads may impact your well-being.
  • Limited Scalability: Unlike passive income, active income is often limited by the number of hours you can work. Scaling your earnings may require taking on more responsibilities or pursuing additional education and certifications.

The trade-offs between active and passive income require entrepreneurs and business owners to minimize risks to ensure financial stability. This is why most individuals have a combination of both active and passive income or have an investment portfolio large enough to weather tough times.

6. What About Owning a Business?

Entrepreneurs and business owners need to pay close attention to active versus passive income when it comes to tax time. Passive income is generated when you don’t play a major role in operations. One example would be ownership in a company where you don’t materially participate and serve as a limited partner. Maybe you’re a silent investor or take a hands-off approach to management. When you aren’t involved in the day-to-day operations or decision-making process, your investment might be considered passive.

On the flip side, if you are heavily involved in operations and management, such as acting as the CFO, president, or CEO, you will most likely have active income. Depending on the structure of your business, some or none of your income will be subject to self-employment taxes. For example, single-member LLCs and sole proprietorships that file Schedule C and multi-member LLCs taxes as partnerships will pay self-employment taxes on the net profit.

However, if you have a pass-through entity, such as an S Corp, your business’s ordinary income won’t be subject to self-employment taxes. This is why choosing your business structure is so important.

7. Passive Activity Loss Limitations

IRS Publication 925 outlines limitations to passive activity losses. A passive activity loss occurs when your passive investment deductions exceed gross income. This commonly occurs when a business incurs a loss for the year. The losses you can claim on your tax return are limited and can generally only be offset by other passive income.


Case 1.

Facts:
  • Margaret works full-time as a business consultant
  • Over the years, Margaret acquired a couple of rental properties
  • Property A generates a monthly rental income of $2,500
  • Property B generates a monthly rental income of $1,500
  • This year, Property A and Property B incurred various annual expenses, adding up to $20,000 for each property
  • Margaret is not a real estate professional, and rental income is passive
Issue:

How does the paring of passive income and passive loss affect Margaret’s taxable income and tax liability?

Calculations:
Result:

Margaret can take a full loss from Property B because passive income from Property A was able to absorb the passive loss from Property B.


Case 2.

Facts:
  • Margaret works full-time as a business consultant
  • Over the years, Margaret acquired a couple of rental properties
  • Property A generates a monthly rental income of $2,500
  • Property B generates a monthly rental income of $1,500
  • This year, Property A and Property B incurred various annual expenses, adding up to $20,000 for each property
  • Margaret is not a real estate professional, and rental income is passive
  • NEW Property A’ renter moved out early in a year, and Margaret was able to collect only 4 months of rent for the year
  • NEW Property A was available and advertised for rent for the rest of the year
  • NEW Property B generates a monthly rental income of $2,000
Issue:

How does the paring of passive income and passive loss affect Margaret’s taxable income and tax liability?

Calculations:
  • Net loss from Property A is ($10,000) [$2,500 x 4 months – $20,000]
  • Net income from Property B is $4,000 [$2,000 x 12 months – $20,000]
  • Net loss from both passive activities $6,000 [$4,000-$10,000]
Result:

Margaret can’t take full loss from Property A because passive income from Property B wasn’t able to absorb the passive loss from Property A. Margaret will report $0 income/loss from her rentals and carry forward a $6,000 loss to future years until the net rental income is created or property A is sold.


There are two exceptions to loss limitation rules.

$25,000 Deduction

  • Taxpayers with adjusted gross income (AGI) under $150,000 may qualify for a limited $25,000 deduction against non-passive income from rental real estate activities.
  • The deduction begins to phase out for taxpayers with AGI between $100,000 and $150,000.

Real Estate Professional

  • The Real Estate Professional exception is the second exception to the general rule that all rental activities are passive.
  • Individuals who qualify as Real Estate Professionals, as defined by specific criteria (such as material participation and meeting the hours test), are exempt from the passive activity classification for their rental real estate activities.
  • Qualifying individuals can use losses from rental real estate activities to offset other income without the usual passive loss limitations.

8. Conclusion

Do you have a passive or active income? It’s not uncommon for entrepreneurs and business owners to have both passive and active income. Nevertheless, it’s important to understand the taxation differences to plan for your next tax filing properly.


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