Working a nine-to-five isn’t the only way to keep money flowing into your bank account. Some people build powerful income streams that keep earning money with little to no ongoing effort.
I know what you’re thinking—and no, I’m not talking about revenge-hacking your company’s mainframe to siphon off a few cents on every dollar (Office Space, anyone?)
We’re talking about active income and passive income. Most people only ever generate active income, but it is possible to earn steady money without lifting a finger. Here’s what you should know about the differences, benefits, and tax implications of active income vs passive income.
What is active income?
Remember when you were little, and people asked you, “what do you want to be when you grow up?” Of course, what they were really asking is, “what do you plan to do to earn yourself a steady, reliable, active income, kid?”
Active income, or “earned income,” includes your salary, wages, tips, and commissions. When you work a job or build a career, you earn active income in exchange for the expertise and labor you provide.
What is passive income?
You can earn passive income when you’re sleeping, watching television, or doing literally anything except working. Unlike active income, passive income is earned without requiring your time or energy after the initial work is done.
Traditional forms of passive income
Many people make passive income through classic investment methods such as:
- Real estate income
- Index funds
- Interest payments
These kinds of investments are excellent because they don’t require much effort on the front end, and you don’t have to do much to manage them once you get started.
Other forms of passive income
In the age of digital media, there are now newer, more creative ways to earn passive income in addition to investing, including:
- Affiliate marketing content
- YouTube video ad revenue
- Audio content
- Website ad revenue
- Selling digital and downloadable content
That podcast you tune into religiously weekly makes tons of passive income off each episode. Your favorite YouTuber who manages to do her makeup perfectly while telling you terrifying true crime stories? She’s building a passive income stream that grows with every view.
The importance of maintaining an active income
Don’t call your boss and quit your job to start a blog selling drones and iPhone cases just yet.
Even when you establish a passive income stream or two, you should continue to work on earning active income. It’s more reliable than passive income, as it’s not subject to the ups and downs of the stock market or any other factors beyond your control.
Active income can also help you qualify for loans and other financial assistance. Want to buy a house someday? Thinking of getting a loan for a new car? That active income can certainly help.
The long-term advantages of passive income
Passive income is an ongoing income stream that doesn’t require ongoing active work—what could be more advantageous than that?
True, it does require some work upfront. For example, investments require time to research and at least a small amount of money to start. Likewise, making money from digital content requires creating, uploading, and devoting time to maintaining your website or channel.
But once you front-load all that effort, you get to keep reaping the financial benefits for exponentially more time than you spent getting things in motion. That’s why passive income can be such an efficient way to improve your financial wellness.
Passive income streams, especially investments, tend to generate money over longer periods. They can compound and grow in ways that active income sources can’t. Eventually, passive income can lead to greater financial stability and freedom.
Paying taxes on active vs. passive income
Any active income you earn is taxed at your marginal tax rate. For example, if you are in the 25% tax bracket, any additional income you earn will be taxed at 25%. Getting a raise, making extra tips, or getting that big commission won’t land in your bank account without a cost.
Passive income, however, is subject to different tax rules. Generally, passive income taxes are lower than active income taxes, but some exceptions exist.
One notable exception is that passive income from certain types of businesses (such as real estate investing) may be subject to “self-employment tax,” which effectively treats passive income as active income. As always, it’s essential to consult with a tax professional to determine how your particular situation will be affected.
Should you start investing in passive income?
If you’re still wondering whether you should diversify your income streams to include passive and active income, here are three questions to ask yourself right now.
Are you willing to invest time and money upfront?
Don’t expect to start earning passive income immediately—most passive income streams take time (i.e. years) and cash to start paying off. For example:
- Building a blog where you hope to earn affiliate income: you’ll need to invest time (and money) into building a website and gathering an audience.
- Getting into real estate can take months or even years to profit from passive income.
- Buying Stocks: requires less time and capital upfront but still takes a lot of time to pay off.
But think of how proud the future you will be when your investments start paying off! If you’re willing to be patient and put some work up front, you’re ready to start building passive income.
Do you have a specific goal in mind?
You’re much more likely to succeed at making passive income if you have some intrinsic motivation guiding you. Be clear about your why for pursuing passive income. Some common goals include:
- Saving money for college tuition
- Buying a house
- Saving for a wedding
- Paying off debts
Without a destination, your passive income goals are aimless, and you may not get much of a return on your investment.
How much of a risk are you willing to take?
Before you start making plans for passive income, consider your risk tolerance. With active income, you can expect a paycheck offering the same amount each week. But with passive income, there are almost always some risks involved, but some options are safer than others.
Less risky income streams, such as investing in high-quality dividend stocks, are all but guaranteed to offer some return on investment. They tend to be one of the most reliable forms of passive income but also provide lower returns.
Other options, such as real estate or investing in a business, can lead to higher rewards—but they also come with greater risks. For example, real estate investors risk depreciating values on property, while businesses always risk going under.
Do you want to be more financially healthy?
If you want to improve your financial wellness, one of the best things you can do is earn more passive income. That’s because, unlike active income, passive income doesn’t dry up if you lose your job or take a pay cut.
Whether you’re saving for retirement or just hoping to build more of a financial safety net, diversifying your income with passive income can help you protect yourself against market fluctuations and life’s surprises.
If we lived in a financially savvy world, we wouldn’t just ask kids what they plan to do professionally to secure active income. Instead, we’d follow up with something like, “how do you plan to supplement your salary as a veterinarian with passive income streams?”
Imagine asking a fourth grader how they plan to build passive income streams! They’d probably look at you like you were speaking nonsense and go back to playing Roblox like you didn’t exist.
But if more people knew about the benefits of supplementing active income with passive income, then maybe it wouldn’t seem like such a crazy question to ask a fourth grader.
Julep is not a financial institution, financial advisor, or credit repair company, and does not provide credit repair services of any kind. The information provided is for general educational and reference purposes only. The information is not intended to provide legal, tax, or financial advice. We do not propose any guarantee that the information provided will repair or improve your financial profile. Consult the services of a competent licensed professional when You need financial assistance.