If we divide the type of income, we can categorize it as passive or nonpassive income. This post will explain the major differences between the two income streams. Also, I will share good examples of each type so that you can have a better understanding. As you read through, you will be able to have a better idea of what passive and nonpassive incomes are and what examples are there.
First, let’s talk about passive income. This is an income type that many people dream of. According to Wikipedia, passive income refers to income generated by regular cash flow. By definition, it requires minimal to no effort by the recipient to maintain the income source. Passive income is basically an income stream that can be earned with little effort. One thing we need to know is that passive income is an official category that the U.S. Internal Revenue Service uses.
IRS has three categories to define income types – active income, passive income, and portfolio income. The organization defines passive income as “only coming from two sources: rental activity or ‘trade or business activities in which you do not materially participate.'” In the U.S., passive income is generally taxable. The government website gives the following example as passive activities:
- Lease equipment
- Rent out real estate properties
- Sole proprietorship or farm in which the taxpayer does not physically participate
- Limited partnerships with some exceptions
- Partnerships, S-Corporations, and limited liability companies in which the taxpayer does not physically participate
If you are from a different country, you need to check your country’s tax law.
This type of income is probably the most common income stream for all of us. Non-passive income is, in another term, active income since a person participates in activities to earn income. According to Investopedia, active income refers to the income you receive by providing a service. Active income comes in the forms of wages, tips, salaries, commissions, and revenue generated from your business.
Wikipedia also defines active income as “Linear active income refers to one constantly needed to stay active to maintain the stream of income, and once an individual chooses to stop working the income will also stop.” One easy example will be an accountant who receives a monthly paycheck as he or she performs service for the employer. Undoubtedly, non-passive income is taxable.
Examples of Passive Income
Many people like passive income because it frees you from continuously working on something to earn money. Earning an active income is relatively simpler than passive income. You can work as a full-time, part-time worker, or as a freelancer, and there is the uncountable number of job types out there. You may have already been earning non-passive income. Then next question may be “how can I earn passive income?”. Or, “what kinds of passive income jobs out there?”
Easy thing first. I believe that most of us receive interest from a bank although the amount may be small. You just put your money in your bank account and your bank gives you a small amount every month. Importantly, you don’t do anything to earn interest. The more money you put the more interest you get. Unless you have huge amount of money, it is difficult to live solely on bank interest. It is especially true when the U.S. government lowered its key rate to 1.75-2 percent according to this source.
Over the past 5 years, the interest rate has risen gradually. However, due to the economic concern, the federal reserve started decreasing its rate. So the return on your money in your bank will also go down.
Regardless of the return, I would say that the bank’s interest is the most typical and basic passive income.
You might have already guessed it. If you have a rental property, you can receive regular rent from your tenant. However, you cannot expect that you’ll be free from managing the property. Even if your real estate agent manages it, there are certain things you need to involve – everything from buying a property to fixing a leaking sink pipe. So, it requires your efforts and time to keep the passive income, but still, the Internal Revenue Service categorizes rental income as passive income.
The return, compared to bank interest, is much bigger because you put (spend) a large amount of money for your property. More money you put in, the more money you earn. This is a basic rule in investment. Even if you have enough money to buy a property, not everyone has a good eye to pick a nice property. I strongly believe that depending on your interest, expertise, and even personality, other passive income types can be more attractive to you.
Dividend from Stock Investment
Same as property investment, there is a risk in stock investment. You have to pick the right stock at the right time. If you do a good job in those, your stock price will go up. When you want to have your increased money returned, you sell it and receive the money. In addition to the materialized return by sale, you can also receive dividends depending on your stock – not every stock gives you dividend.
If you invested in the stock that pays out dividends, you don’t have to do anything. You put your money in that stock and you just receive the dividend regularly. In that regard, it is similar to bank interest. According to dividend.com, “Most companies pay dividends quarterly (four times a year), meaning at the end of every business quarter.” So it is less often than bank interest. But the RoI (Return-on-Investment) is larger than bank interest.
Please be aware of the risk you have to take. Stock investment is challenging. If you pick a wrong stock and its price goes down, even though you can still receive the dividend, your loss of principle can be larger than the dividends you’ll receive.
I just mentioned that there is a risk in real-estate and stock investment. However, although you cannot totally remove a risk, there is a way to mitigate the risk by using a paid service. There is a lot of automated stock investment service that provides a high-yield portfolio, and you can just put your money in there. For real estate investment, there is a trust called Real Estate Investment Trust or REIT.
They own real estate properties so you don’t have to buy a property by yourself. When you invest your money in, you will gain ownership of properties depending on your investment money. As the owner, you will benefit from the investment returns. Since you are the owner, when something goes wrong with the property, you will also get damaged. But, with REIT, you can just choose properties within what they have and you don’t have to go through complicated paperwork as you would normally do when you do property investment alone.
Which income type do you want to focus on?
Although I’m not a professional investor, I have some experiences in stock investment, real estate investment, and running this blog for a passive income in the future. It could be different from your circumstances, but I think most of the people like me have a full-time job. And, I believe that’s safer.
If you inherited huge amount of money from your parents and you can make a living out of bank interest, you may not need an active income and not need to take any risk for the other passive income types. If that’s not you like me, you need an active income first. You should first focus on building your career to get a regular job or starting and managing your business until it generates meaningful revenue. Your active income should be there to support your passive income activities so that even if you fail in your passive income, active income should be able to keep supporting you.
Passive Income Trend
To be honest, there is nothing very special about active income. The income type existed for many decades, and when people think about a job or making money, it is the active income that comes to their mind first. What about passive income? It also has existed for many decades, but it seems like it is getting more interest from people.
According to Google Trend, people increasingly searched “passive income” on Google over the past 5 years. If this trend continues, it is likely that people’s interest in passive income would continue to rise. If we compare passive income against “active income” and “nonpassive income”, we can see the stark comparison as below.
The blue line is passive income, the red line is active income, and the yellow line is nonpassive income. As you can find, passive income has gained much more interest over that period from people.
Why more interest in passive income?
We found that people’s interest in passive income has been on the rise for the last 5 years. I believe that the reason is that there is a massive opportunity to make passive income in addition to active income. If you google “passive income”, you will have an endless supply of search result introducing various examples including writing an ebook, running a blog, selling products online, and more. All of these are possible thanks to the Internet.
It is not a secret that a successful YouTuber earns more money than a small company. Many people share how to earn money using social media like Facebook, Instagram, and more. As many more people actively engage in online, the popularity of earning passive income online will also increase. Then, what do you need to generate passive income?
Two essential elements for passive income
Please let me share what I learned about passive income and the two essential elements for passive income. I know you will be disappointed by hearing this because it is quite obvious. What I learned from my experiences is that you need time and money to build a passive income. If you have money, you can use it to bring in more money. Remember bank interest, stock dividends, and rental investment. Also, if you want to spend time, you can write an ebook, build a blog, make online courses and etc.
What does this tell us? It tells us there is no free passive income. You have to spend your time or/and money to build passive income.
In this post, I explained the differences between passive and active income and introduced basic examples. I want to recommend to secure active income first and then move on to passive income. Lastly, please be ready to spend your time and money to build a passive income stream. Also, choose the right passive income source that fits your interest, expertise, and personality.
As I did the research for this article, I found the relevant story.
“the story of Bruno and Pablo where Pablo works hard to set up a pipeline for water instead of carrying the water buckets every day and as a result of his hard work, Pablo succeeds in growing the business exponentially whereas Bruno earned very less even after carrying the water buckets daily.” Quora
It will need your time and money, but don’t give up. Build your pipeline for your long-term gains.