Many or all of the products featured on this page are from our sponsors who compensate us. This may influence which products we write about and where and how the product appears on a page. However, this does not influence our evaluations. Our opinions are our own. Here is a list of our partners and here is how we make money.
The information provided on this page is for educational purposes only. The Modest Wallet is a financial publisher that does not offer any personal financial advice or advocate the purchase or sale of any security or investment for any specific individual.
The concepts of passive and active income have become popular as part of the whole financial freedom trend.
These two concepts are used to categorize how money is earned, and understanding them correctly can help you achieve your financial goals faster and perhaps more easily.
Robert Kiyosaki, the author of many best-selling books on personal finance including Rich Dad, Poor Dad, popularized the concept of passive income by stating that financial freedom can only be achieved when someone secures enough passive income sources to supplement their living expenses and achieve his/her financial goals.
In this article, we provide a detailed overview of what passive and active income are, how they are different, and how you can earn money in both ways.
|Passive Income||Active Income|
|Money works for you||You work for money|
|Can be earned without much effort||Requires a greater level of effort to earn|
|May not require material participation||Requires material participation and involvement|
|Can be a way to supplement income||Can be a means to fund passive endeavors|
|May be unpredictable and can take years to accumulate||It’s predictable and an immediate flow of financial resources|
|Your time is not exchanged for money so you have more freedom||Your time is tied to an activity and exchanged for money|
|Income may be subject to tax deductions||Your income is subject to taxes|
|Examples: dividends, rental income, interests, royalties, etc.||Examples: salaries/wages, side hustles, consulting, tips, etc.|
What Is Passive Income?
The concept of passive income refers to money earned without too much effort or involvement on the part of the person receiving the income.
The time invested to generate passive income is typically low after an initial effort is made, and these sources typically give people enough free time to enjoy other activities such as developing other income-generating activities or simply enjoying a vacation or a well-deserved rest.
Examples of Passive Income
To better understand this concept, check out the list of some of the most common examples of passive income sources below.
Stocks are equity instruments that entitle the holder to receive compensation in exchange for investing in a certain business. Shareholders can be compensated via the payment of dividends or through increases in the value of their stock. A dividend is a periodical payment received by shareholders that is taken from the company’s earnings.
A dividend stock is one that offers an attractive and stable dividend yield. A dividend stock can be a great source of passive income, as investors can rest assured that they will receive their distributions as scheduled.
Rental Income From Real Estate
Real estate investors can generate passive income from their properties by leasing them to a third party in exchange for rent payments.
As long as the tenant is solvent, real estate properties can generate a steady stream of passive income for the owner. That said, rental income should be estimated as the net amount received by the investor after deducting property taxes, maintenance expenses, and other costs associated with owning the property.
The internet has created multiple potential sources of passive income, including the possibility of promoting products and services rendered by a third party in exchange for a commission or fixed fee.
Website owners, social media influencers, and bloggers can generate passive income through affiliate links and promotions. Most affiliate programs compensate their publishers periodically if a customer completes his/her purchase or registration.
Ad Revenue From a Website
Another way to monetize a website or any other form of digital presence is to let other businesses advertise their products and services in exchange for a part of the compensation. Platforms such as Mediavine and Google AdSense give website owners the possibility of displaying ads that will generate money based on the number of impressions or clicks they get.
Since most of the time invested in building a website is spent at the beginning of the process, the money produced by these digital assets is considered a passive income source in most cases.
Royalties are a fixed commission or fee paid for giving a third party the right to sell, distribute, or commercialize a certain product or invention.
There are different types of royalties that are classified based on the underlying asset involved in the negotiation. Product royalties are paid by a company for the right to sell something that was invented by somebody else.
Resource-related royalties give a company the right to exploit a certain natural resource found in a property owned by somebody else.
Meanwhile, intellectual property (IP) royalties give companies the permission to commercialize or use the patents, technology, trademark, or brand owned by a third party with a certain purpose — whether that is to commercialize some products under that brand or incorporate that technology to the business’s manufacturing process.
Finally, royalties can be earned by allowing third parties to open a franchise. Good examples of this are McDonald’s and Krispy Kreme. Both companies offer a franchise model in which a third party can operate a store that is not directly owned by the company. In compensation for using the parent’s company brand, products, and trade secrets, the store owner pays the parent a royalty.
Royalties can be negotiated as a percentage of the sales generated by the product that is being commercialized under the agreement, a fixed dollar amount per product sold, or a fixed periodical payment.
Peer-to-Peer (P2P) Lending
Peer-to-peer lending is an activity that involves taking the role that is typically assumed by banks and financial institutions to lend money directly to a person or business.
Companies such as Prosper have popularized this practice by creating platforms through which these loans can be negotiated and settled. The platform allows lenders to screen borrowers based on their creditworthiness and track record within the community.
A diversified portfolio of P2P loans can generate a steady stream of income for an investor, and the only effort required to produce money out of this activity is the time invested in selecting the loans that will be funded.
Pros of Passive Income
- Requires little to no effort to be produced
- Gives the person free time that can be devoted to other activities
- Can supplement the person’s living expenses
- Can be used to achieve financial goals faster
- Can be passed on to the next generation
- Can lead to financial freedom
- Taxes are usually lower
Cons of Passive Income
- Can be volatile depending on the kind of arrangement that produces it
- Can be a while before a person can make a living out of it
- May not produce an attractive return on investment
What Is Active Income?
Active income refers to money obtained in compensation for a person’s performance, time, or effort invested in a certain activity.
In most cases, active income is earned on the basis of how many hours are spent working or per project. This is the most common way of earning money.
Examples of Active Income
The following is a non-exclusive list of active income sources. You are probably familiar with some of them.
A salary is a fixed payment received from an employer in exchange for fulfilling a certain role within an organization. Salaries are typically paid on a weekly or bi-monthly basis.
Salaries can be expressed on a gross or net basis depending on whether the figure includes deductions such as taxes, health insurance, or mandatory contributions to a retirement account.
An hourly wage is paid to workers who perform an activity that is directly associated with the manufacturing process of a company. The amount paid per hour is convened with the employer based on the worker’s skills and the predominant conditions of the labor market.
Hourly wages can be paid weekly. In some locations, the minimum hourly wage is set by the government, and companies are not permitted to offer anything less than that amount regardless of the nature of the job performed.
Workers in the service sector are typically compensated by customers directly depending on the quality of the job performed. These payments are known as tips and are typically calculated as a percentage of the total amount spent by the customer.
Tips are usually a supplement to a person’s base salary, and they can vary widely depending on the worker’s performance and the kind of establishment they work in.
Commissions are earned by people who work in the sales department of an organization as a supplement to their base salary — if any. These commissions can be calculated as a percentage of the amount sold or following a certain scale based on the volume of goods sold.
Income From Freelancing
Freelancing involves the performance of a certain activity as an independent contractor. The relationship between the organization and the person is limited to the scope and nature of a certain project, and compensation is typically negotiated beforehand.
Freelancing is typically viewed as a side income for regular workers, but there are also individuals who perform these activities on a full-time basis.
Income From Consulting
Consulting involves providing professional advice to an organization or individual about a certain topic. Similar to freelancing, consulting jobs can generate extra income for a 9-to-5 worker as long as the work is performed outside of their regular work hours.
Consulting fees vary depending on the person’s track record, academic background, and specific skills. In some cases, consulting can become a full-time activity.
Pros of Active Income
- It is considered a stable source of income as it is paid by an organization following the stipulations of a legally binding agreement — a job contract
- It is predictable and allows individuals to better plan their personal finances
- It is typically taxed as ordinary income
- Some sources of active income come with added benefits such as health insurance and retirement contributions
- Some organizations may continue to pay individuals under certain circumstances — health issues, maternity leave, etc. — even if they are unable to perform their regular activities during a certain period
Cons of Active Income
- There is limited room for growth
- The amount of effort invested into the activity might not be adequately compensated
- An increase in the amount perceived needs to be approved by a third party
Passive Income vs. Active Income FAQ
We’ve found some of the most frequently asked questions with regards to passive income and active income and listed them below.
Which Is Best? Active Income or Passive Income?
Passive and active income are different ways of producing money. The best one depends on one’s financial and personal goals. For example, active income sources are typically necessary for most people in the process of developing passive income sources.
Without active income, a person would not be able to save enough money to make worthwhile investments that can generate passive income.
That said, having multiple sources of passive income that generate enough money to cover a person’s living expenses along with helping them achieve certain financial goals is typically considered the ideal arrangement.
Why Is Passive Income Important?
Passive income can speed up the process of achieving certain financial goals, and it can be a great hedge in case a person falls ill or suddenly can’t generate money from his regular job.
Moreover, passive income is a great way to pass on wealth to the next generation, and it can make a person’s retirement much more enjoyable if money can continue to be produced out of these sources even at an advanced age.
What Are the Pros and Cons of Passive Income?
Passive income can be, at first, a great supplement to the money earned through traditional work activities. However, as time passes and the amount invested into building a passive income source increases, a large enough passive income can lead to financial freedom.
That said, passive income can be unpredictable, and that can be stressful for people who rely on this money to cover their living expenses.
How Is Passive Income Taxed?
The way passive income is taxed depends on how the money is generated. Dividend payments, rental income, royalties, and other similar sources are taxed as ordinary income.
Depending on the vehicles used to make these investments, taxes can be reduced or waived.
Understanding the differences and benefits of passive and active income sources is crucial to accelerating the achievement of a person’s financial goals. In the near term, most people might find it difficult to generate enough passive income to finance their lifestyle.
However, by progressively saving and investing money into activities that can generate passive income, a person can eventually achieve financial freedom and retire happily from their 9-to-5 job.
Get our free Stock Market Playbook to learn how to invest your first $500 in the stock market.
Plus our best money tips delivered straight to your inbox.
Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.