Passive Income Vs. Active IncomeDifferences You Need to Know Between the Two!

Lisa Borga

Date Published: September 21, 2022

Income is the money that a person or company earns through providing a good or service or through making investments.

Income is often divided into two primary categories, which are active and passive income.

There is a considerable difference between these two categories both in the manner in which the income is acquired and the level of hands-on effort that is spent in earning it.

Active income is income that requires the earner to materially participate in earning it, such as through providing a product or service.

Essentially, active income involves trading time for money, such as through receiving pay for a full or part-time job.

On the other hand, passive income is money that is earned from an enterprise without requiring significant time or investment.

Commonly this is the result of returns on investments such as dividends or income from rental properties.

The distinction between these two sources of income is significant both for building diverse and dependable sources of income and for tax purposes.

Active Income

Active income refers to income earned as the result of the direct investment of time and effort.

This income is the primary source of support for the majority of individuals and is most commonly earned in the form of wages, salaries, and other forms of compensation resulting from employment or income from material participation in a company.

Essentially active income results from trading time for money. Active income is important for offering a quick and consistent form of income.

Generally, when compared with passive income, active income offers larger returns over a short period of time.

Additionally, active income generally provides the basis of cash upon which investments to create passive returns are based.

Though active income will always result from an active investment of time and effort, it can take several forms.

This includes but is not limited to hourly wages, salaries, tips, commissions, and material participation in a business.

In the United States, active income is taxed as ordinary income at rates that depend upon the amount of income a taxpayer earned.

These rates work on a system of progressive brackets so that the more active income a taxpayer earns, the larger their tax burden will be.

Advantages and Disadvantages of Active Income

 

Advantages

  • Active income can generally provide much more money in a short period of time than passive income.
  • With active income, an individual can often develop a skill or expertise that they can use to consistently earn money

Disadvantages

  • In order to acquire active income, both significant time and effort must be spent, which means less time for performing other activities.
  • Because time must be spent earning active income, this often means that there is a lower possible earning threshold than with passive income.
  • Active income is often taxed at a higher rate than passive income.

Passive Income

Passive income is income that is earned with a minimal investment of time and effort. This is often earned by individuals and companies alike through investment in an income-earning asset. This income stream is passive because it does not require the earner to be present or take active action in order to continue earning money.

However, passive income typically requires an initial investment of money, generally acquired from active income in order to acquire it. But, once an investment in a passive income source is made, it will often continue to be earned long after the investment is made.

Though passive income often pays relatively little over a short period of time and can take years to accumulate, it can provide significant tax benefits and financial security relative to active income.

Because it is not tied to the active effort, passive income can provide a layer of security against a loss of employment.

There are many potential sources of passive income, including:

  • Interest income earned from savings accounts, investments in bonds, and other financial tools
  • Dividends from stock investments
  • Real estate held for rental income
  • Display advertising
  • Royalty income from previous work
  • Self-charged interest
  • Peer-to-peer lending
  • Silent partner in a partnership

Though earning income from these enterprises may require significant time and work upfront, they will continue to earn money often for many years without requiring any additional effort or attention.

Advantages and Disadvantages of Passive Income

active vs passive income

Advantages

  • Passive income sources can continue to generate money no matter what an individual is doing. This includes potentially generating another active income source.
  • Passive income can continue to scale without the time constraints that exist with active income sources.
  • Passive income is often taxed at lower rates and is subject to potential tax deductions.

Disadvantages

  • In order to create sources of passive income, active income often must be earned first.
  • Passive income is often more difficult to generate than active income.

Active Vs. Passive Income

Active and passive income are highly different both in the ways they are earned and in the amount of active time and attention that goes into earning them. Active income generally comes from active employment and is the regular source of income for most people.

Passive income often acts as a supplementary source of income that requires little time or attention to earning. However, just because it is not always necessary to actively work to earn passive income, this does not mean that an individual may not need or choose to do so in some cases. Particularly in the case of self-employed individuals and those participating with others in business activity, it can be difficult to distinguish between active and passive income.

Due to this, the Internal Revenue Service (IRS) has created some guidelines for distinguishing between what constitutes active and passive income. If income from a given enterprise meets any one of the following criteria, it is regarded as active income:

  • The taxpayer works at the business for 500 or more hours in the year.
  • The taxpayer performs most of the work in the business.
  • The taxpayer works for 100 or more hours at the business, and no one else works more hours.

How Active and Passive Income Is Taxed

A significant benefit of passive income is the preferential way in which it is taxed.

Active income is taxed as ordinary income, which means that it will be taxed using the regular federal income tax brackets, which can be as high as 37% in the tax year 2021-2022, as well as state income tax, if any.

On top of this, active income is subject to FICA taxes of Medicare and Social Security, which will total out to 15.3% up to certain limits.

In contrast, passive income will generally be taxed in one of two ways, either as short-term or long-term capital gains, both with their own tax treatment. Short-term capital gains result from the sale of assets held for a year or less and include income from rental properties and several other passive income sources.

Short-term capital gains are taxed at an individual’s ordinary income tax rate but are not charged FICA taxes and can benefit substantially from tax advantages, including MACRS depreciation, claiming expenses for repairs, maintenance, and property taxes, as well as other tax deductions.

Since the passage of the Tax Cuts and Jobs Act, long-term capital gains are taxed very differently from active income, and short-term capital gains are not subject to FICA taxes.

Long-term capital gains come from investments that are held for more than a year and are taxed at a low end of 0% to a high of 20%, which are significantly lower than ordinary income tax rates, which range from 10% to 37% in the 2021-2022 tax year. For taxpayers on the high end of these tax rates, it is easy to see how much they could save by paying 20% on income vs. 37%.

As a result, many investors attempt to classify as much of their passive income as long-term capital gains as possible.

In practice, one of the most common sources of long-term capital gains comes from qualified dividend income. These are dividends that meet the IRS’s standards to be taxed at a lower long-term capital gains tax rate. Generally, in order to qualify, the stock must be held for 60 days for common stock and 90 days for preferred stock.

In most cases, taxpayers will benefit from attempting to classify as much of their passive income as possible as long-term capital gains in order to benefit from the lower tax rates. In many cases, this may be possible through holding investments for a longer period of time.

Final Thoughts

Active and passive income are two different ways of earning money. Active income is earned through an investment of time and effort, whereas passive income will generally be earned with little to no investment of time.

Active income is most often earned from a full or part-time job and may be used to invest in supplemental passive income sources such as stocks or rental property. Once the passive income is earned, it can be used to continue expanding without the time constraints that exist with active income sources.

Key Takeaways

  • Active income is income received from spending time and effort to earn money. Most commonly, this is earned from an individual’s job or material participation in a business.
  • Passive income is money earned from an activity that requires little to no investment of time or effort. Commonly this income results from investments or work that was completed in the past and continues to generate income.
  • Passive and active income are generally taxed at different rates, and classifying income correctly between these two categories can help taxpayers to reduce their annual tax burden.
  • Generally, active income must be earned in order to begin investing in generating passive income.

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  1. Internal Revenue Service "Publication 925 (2021), Passive Activity and At-Risk Rules" Page 1 . September 21, 2022

  2. Cornell Law School "26 U.S. Code § 469 - Passive activity losses and credits limited" Page 1 . September 21, 2022