Passive income vs. earned income: what’s the difference? Is one better than the other? And how do you grow your passive and active incomes?
In the simplest terms, passive income is money you earn without actively investing time on generating that income, while earned income is money that ties directly to your current, active efforts. But the real difference between passive income vs. earned income is a bit more nuanced, as you’ll see when we look at some examples.
As a quick side note, the active component of earned income is why you’ll often see “earned income” and “active income” used interchangeably. We will use both terms interchangeably throughout this article.
Without further ado, let’s explore the differences between passive income and earned income.
What is Passive Income?
As a general term, passive income is any money earned without a direct correlation to your active efforts. Passive income is how you earn money while sleeping, vacationing, or enjoying your hobbies. It might sound too good to be true, but people earn passive income every day, all over the world.
While passive income doesn’t require your active involvement to flow, it typically requires something from you. An upfront cash investment, for example, can deliver passive income for decades to come. This is the case with passive investment models like investing as a silent partner in a limited partnership (which we’ll discuss in a bit). Alternatively, you could invest your time upfront, creating something that will generate a passive income stream. Consider writing a book, for example. You may invest hundreds of hours upfront without any compensation, but once your book hits the market, it can generate cash for you without any further action needed on your end.
We’ll look at more examples in the next section, but we want to make it clear that passive income isn’t an unrealistic get-rich-quick scheme. It’s a legitimate way of creating recurring income by leveraging an investment of time, money, ingenuity, or a combination of all three.
Passive Income According to the IRS
The IRS has its own definition of passive income. According to the IRS, passive income is the income made from passive activities, of which, there are only two:
There are two kinds of passive activities. 1) Trade or business activities in which you don’t materially participate during the year. 2) Rental activities, even if you do materially participate in them, unless you’re a real estate professional.
The IRS makes the distinction between passive income vs earned income because they are taxed differently. Earned income is taxed as ordinary income, based on the income tax rate for your tax bracket. Passive income is typically sheltered by tax breaks like asset depreciation before being added to your taxable income.
The IRS definition of passive income is important because it helps you to understand and limit your income tax liability. But, for the purpose of this article, we’re going to focus on the more general definition of passive income.
What Are the Most Common Types of Passive Income?
- Rental property investments (even if you actively manage the property yourself, the IRS considers this to be passive income, unless you are a real estate professional). Rental properties are one of the primary ways an investor can become a millionaire through real estate investing.
- Limited partnerships
- Selling pre-made digital products (courses, eBooks, photographs, graphics, etc.)
- Selling monthly subscriptions to ready-made products like apps or digital libraries
In addition to these passive income types, there is another category that the IRS refers to as “portfolio income.” For all intents and purposes, portfolio income is passive income, but the IRS treats them differently, typically taxing them at capital gains rates rather than earned income rates. Investing in real estate without buying property often generates this type of passive portfolio income, which includes:
- Dividends
- Interest
- Capital gains
- Royalties
What is Earned Income?
Earned income is income received from being employed or having your own business. If you are compensated for your active work, you are earning active income.
Earned income can only grow by
- Increasing your rate per hour, year, or project, or
- Increasing the amount of time you work.
What Are the Most Common Types of Earned Income?
The most common types of earned income include:
- Salaries
- Hourly wages
- Commissions
- Freelancing income
- Consulting income
- Flipping houses (which is typically considered an active business activity by the IRS)
Benefits of Passive Income vs Earned Income
While passive income and earned income both have a place in our economy, passive income provides greater benefits than earned income. Here are just a few of the reasons why passive income is better than earned income.
Improved Financial Stability
When you rely on earned income, you leave yourself vulnerable to job market changes. Losing your job means losing your income. Even if you’re able to quickly find a new job, this comes with substantial stress as you worry about how to earn a living and support your loved ones. Passive income allows you to diversify your earnings so you can mitigate this risk.
And since passive income streams are independent of your earned income, you can use the extra income to pay down debts, save for retirement, or enter new investment opportunities.
Compounding Interest Potential
Compounding interests is the main reason why you should start investing early. It’s the principle of earning interest on the interest you’ve already earned. Because of this exponential growth, the more time you give your money, the greater it will grow.
With passive income, you have the option to roll your earnings into other passive income streams, which allow your earnings to compound in the same way!
Preservation of Your Time
With earned income, you’re limited by the number of hours in a day. Even if you’re willing to work more, you can only do so much. But since passive income is not bound to your active involvement, you can have many different income streams working for you round-the-clock.
Imagine what this means for your lifestyle! Instead of working more hours, you can spend more time with family, take more vacations, start a new passion project, or retire early.
Tax Benefits
We’ve touched on the fact that the IRS treats passive vs earned income differently, and while a complete discussion of income tax is outside the scope of this article, it’s important to note that there are substantial tax benefits to passive investments like real estate.
Take long-term capital gains tax, for example. If you own a property for more than a year, your effective capital gains tax could be as low as 0% or as high as 20%, still far below the current maximum income tax rate of 37%. In fact, there are eight different tax benefits of real estate investing! Lower taxes means you get to keep more of the money you’ve earned (whether passively or actively).
Increase Your Passive Income with Gatsby Investment
Real estate consistently serves as one of the most reliable ways to generate passive income. And with Gatsby Investment, real estate investing has become more accessible and more convenient than ever before.
Gatsby is an LA-based real estate syndication firm that scouts deals with the greatest yield potential and offers stakes in these deals to accredited investors for as little as $10,000. With low minimum investments, you can quickly and easily build a real estate portfolio to generate wealth. And, unlike most real estate crowdfunding providers, with Gatsby, you get actual ownership of the underlying real estate, not just ownership over the mortgage debt.
Gatsby proudly offers a variety of investment types, including house flips, new developments, and long-term rentals, serving both short-term and long-term investors. The team of experienced professionals handles every detail from acquisition through construction/development and design, making all incomes passive for investors. You can invest in a quick house flip without ever lifting a hammer or overseeing a contractor. Or you can invest in long-term rentals, which generate a recurring passive income (as rental income proceeds are distributed quarterly).