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Passive income vs. active income: Key differences to know

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6 mins

It’s the stuff dreams are made of: sipping a tropical drink on a beach of white sand while direct deposits of profits from your real estate holdings or investments are flowing in.

Or is your dream working in a profession that you’re passionate about: providing compassionate care as a nurse, caring for animals as a veterinarian, or helping the sick and injured as a paramedic?

These are two very different ways of earning income. One way is making money from an asset that you’re not actively involved in (passive income), and the other is receiving income from performing a service, such as working a full or part-time job (active income).

Passive income (sometimes called “mailbox money”) looks more intriguing, but looks can be deceiving.

Active income (sometimes called “working for a living”) appears much more difficult and tiresome. But, many people prefer it because it does have its advantages.

Let’s take a deeper look at each. Then, you can decide.

What is active income?

One stanza from the chorus of the song “9 to 5” is:

“Working 9 to 5, what a way to make a living
Barely gettin’ by, it’s all taking and no giving”

It’s catchy alright, but does it tell the whole story? Many people have led very fulfilling lives trading their time for dollars. Like anything, there are always pros and cons — let’s apply that to the topic of active income.

Pros of active income

  • You’re probably getting employee benefits like life, health, and disability insurance. Most large employers also offer employees the opportunity to participate in a retirement plan, as do some small companies.
  • You have unemployment insurance. The pandemic has cost many people their jobs, and they were able to keep their heads above water financially because of receiving unemployment benefits, state and federal.
  • You can form relationships that last a lifetime. For many people, some of their closest friends are current or past co-workers. Spending 40+ hours per week working alongside other people can create some solid bonds and enjoyable comradery.
  • You have someplace to go and work every day. Some people just can’t work at home. They don’t like the solitude, and they don’t mind the quiet time during their commute.
  • You like having a career path. Building a career and “moving up the ladder” is an important goal for many people who work for someone else. They enjoy the challenge and the pay increases that come from being rewarded for a job well done.

Cons of active income

  • You’re limited by time. Someone once said, “Time is more valuable than money. You can always get more money, but you can’t get more time.” There are a finite number of hours you can work in a day, which restricts your income — especially if you’re paid by the hour.
  • Your income tax rate may be higher. The top tax rate for individuals is 37 percent in tax year 2021, almost twice as high as a passive investor pays on long-term capital gains.
  • You’re answerable to someone else. In corporate America, everyone answers to someone else, including the CEO, who answers to the company’s Board of Directors.

[ Related: 1099 vs. W2 employee: Pros & cons ]

What is passive income?

A song title that depicts the life of the passive income earner is “I Did It My Way.” It’s a powerful song that paints a picture of someone charting their own path successfully — like a successful investor.

The list of pros and cons for passive income is shorter than it is for active income, but it’s powerful.

Pros of passive income

  • Lower tax rates. The tax rate for long-term capital gains tops out at 20 percent, depending upon how long you hold the asset. This applies to qualified dividends as well.
  • Your time is your own. You don’t have to report to anyone else, and you’re not dependent on anyone for a raise in pay.
  • The sky’s the limit. You’re not paid a salary or paid by the hour; you have unlimited earning potential. There is no ceiling on how many investment properties you can own or how much money you can earn in the stock market.

Cons of passive income

  • Less security. This may be debatable since many people believe they’re in total control as passive income earners. But stock markets crash, and real estate markets collapse. Passive income isn’t guaranteed.
  • Going solo can be lonely. Many people that earn income passively have limited interaction with others. They’re frequently alone in front of a screen watching news and markets so they can stay on course.
  • No benefits. You have to find and buy your own insurance, fund your own retirement, and pay the full Social Security due on your earnings.

Either way — protect your income

No matter how you earn your income, it has to be protected from loss due to illness and injury.

If you earn income passively, you may think that you don’t need disability income insurance or that you won’t qualify because you don’t have an employer. Understandable, but not entirely accurate.

Let’s say you buy and sell homes as an investor, or you’re a silent partner in a business. Either way, you probably travel to see the properties or the company from time to time, and your income depends on it. If the unforeseen happens and you can’t leave the house for a year, would that affect your income? You still may have an income stream from assets you already own, but you might not be able to generate any new income. That’s when more money comes in the mail for you — a check from the insurance company.

If you work for someone else or are self-employed, you also need to have disability insurance. In most cases, when you can’t provide your services, your income will drop or stop quickly. Disability insurance keeps your paycheck coming if you can’t work and earn. The premiums average 1-3% of your income, which is well worth it.

Protect your income with disability insurance.

How about multiple streams of income?

Now that you’ve seen the pluses and minuses of both active and passive income, does one look more alluring to you than the other?

Consider developing multiple streams of income if your lifestyle allows you to. You can have the security and all of the benefits of working for a company and, at the same time, engage in an activity that generates passive income, like investing in real estate, trading crypto, being an angel investor, etc.

Not putting all of your eggs in one basket in 2022 just might provide the boost in income you’ve been looking for.

Having grown up in upstate New York, Bob Phillips spent over 15 years in the financial services world and has been making freelance writing contributions to blogs and websites since 2007. He resides in North Texas with his wife and Doberman puppy.

The information and content provided herein is for educational purposes only, and should not be considered legal, tax, investment, or financial advice, recommendation, or endorsement. Breeze does not guarantee the accuracy, completeness, reliability or usefulness of any testimonials, opinions, advice, product or service offers, or other information provided here by third parties. Individuals are encouraged to seek advice from their own tax or legal counsel.

— Published November 23, 2021
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