If you’re interested in financial independence, understanding active vs. passive income is vital.
Visualize a waterwheel. A waterwheel transfers energy from the movement of water to the paddles of the wheel, causing it to turn. Each turn of the wheel then transmits power to the gears of a machine that does work.
In this analogy, the machine’s work is to create money—it generates income.
Active income is when the waterwheel doesn’t turn on its own. You are the water. It’s your job to turn the wheel.
Either you’re an employee, and someone else owns the wheel, or you own the wheel as a business owner. But in either case, you need to keep that wheel turning. The water to power it doesn’t flow on its own. It’s a lot of work, and when you stop putting in the labor to turn the wheel, the income stops.
Passive income is when you either build or buy a waterwheel on moving water. Your work is to maintain the wheel, not turn it—the water turns the wheel for you.
Building a wheel takes a lot of effort, and there’s the risk you’ll get nothing from your labor. Someone might install a dam upstream. Also, you can’t just walk away because, without maintenance, the wheel could get jammed up.
But there’s a lot less work to do once you complete the challenging work of building that waterwheel.
You may not even need to maintain the wheel in some cases, like when you buy a piece of a “hands-off” business. This leads us to the third scenario, portfolio income.
Portfolio income is when you buy a piece of an existing waterwheel system, and someone else does all the work. It’s completely passive income.
You purchase “paper assets” or the rights to the income generated by the machine. Someone else operates and maintains the waterwheel and the water flow.
The system could break, and there’s the possibility you could lose money. Because of this, your work is to figure out the right system(s) to buy for the risk level you are willing to take.
Before we begin, please note this article is for educational purposes only. My primary goal is to explain the differences between the three types of income. I’ve done my best to provide U.S. tax guidelines, but please do not rely on this for your personal situation! IRS (Internal Revenue Service) rules are complex and frequently change, so consult a tax professional for questions.
Okay, now that’s out of the way, so let’s dive in.
What Is Active Income?
Active income is the money you earn by providing a service. You trade your time for money. Once you stop working, the money stops coming in.
The most common type of active income is job income—the money you earn working for someone else as an employee. It includes salary, hourly wages, commissions, or tips.
If you need money right away, this is the best place to start. Soon after you’re hired, the money can flow in.
Income earned as a freelancer is also active income since it’s earned by providing services. A few examples of freelance businesses are consulting, coaching, and writing.
Even if you own a business, if you need to show up every day to perform services for customers or manage the employees or contractors who provide those services, it’s active income.
Having your own business can give you more freedom than being an employee. However, if your business requires your presence, your freedom is still limited. Having trusted employees can cut down on the work you do, but you probably can’t just walk away.
Active income is the income stream you want to make optional in your pursuit of financial freedom. However, unless you were born into wealth (or you’re a natural-born entrepreneur), you’ll begin here. But you don’t need to stay here.
This is why saving and investing money is critical. You use the money earned as active income to build your passive or portfolio income.
What is Passive Income?
Passive income is money you earn from assets you’ve either purchased or created. It’s considered passive income because the asset (your waterwheel) generates money for you with minimal effort on your part.
Okay, here’s where it can get confusing. There is passive income per the IRS. Then there is the popular concept of passive income you’ll see all over the internet.
According to the IRS, passive income is when you purchase a portion of a business and receive income without “materially participating.” Or if you buy real estate and earn rental payments (and you aren’t a real estate professional). The rules for “material participation” are defined in IRS publication 925.
The popular definition of passive income, usually for online entrepreneurs, is when you create a business that eventually generates revenue streams that require little work to maintain. The work is done upfront, and then, like in our waterwheel scenario, the wheel turns without you.
But the very act of creating a business is active work, and this income is generally taxed as active income (depending on how you set up your business). Unless you meet some specific criteria, this is not passive income per the IRS.
Still with me?
So here we’re talking about building a business that will generate income that’s passive to you. But most likely, it’s active income, according to the IRS.
Why does this matter? There can be different tax rules for income the IRS deems as passive. Also, this can help you when you talk to your accountant, and you’ll know why they’ll stop you if you call your online business income “passive.”
Build Your Own Passive Income Stream Waterwheel
It’s important to bring passive income streams into your life because passive income is what makes financial freedom possible.
However, unless you can afford to buy a passive income business, it requires upfront work. Not a little work, but a lot of work.
You do the work to build your business. Then, if you’re successful, you get to reap the rewards. Again, unless you are buying a business, there are no shortcuts to doing the work. People selling shortcuts are why the topic of passive income can be a seedy, scam-ridden section of the internet.
Also, with the potential for high rewards comes the potential for loss. You could put in the effort and get nothing for it. Even worse, you could lose money.
One beautiful thing about the internet is you can create an online business inexpensively. You used to need significant money to start a business, or you’d need to (gulp!) take out a loan. Now the biggest risk can be your time.
The best way to offset this risk? Don’t start a business you don’t enjoy working in. That way, if it doesn’t work out, at least you enjoyed the work along the way. Pick something that develops a skill you want to get better at.
One more thing. No business you need to run has completely passive income.
Why? Two words: change and competition. Either one of these can wipe out businesses.
So, with all the risks, why bother?
Because building a passive income business can give you time freedom. You can break the link between trading time for money.
Here are a few examples of online business models with “passive” income. Almost all these income streams require you first create a content site, like a website, blog, or YouTube channel. Then you need to build an audience for your content.
- Sell ads. Advertisers (like Adsense) will pay you based on the traffic you drive to your site.
- Earn affiliate income. These are referral commissions you receive when people purchase an item you’ve recommended. The Amazon affiliate program is one of the largest, although they keep cutting their commissions.
- Create information products. You could create and sell an ebook, spreadsheets, printables, etc. Create it once, set up a system to deliver to customers, and enjoy (mostly) passive income.
- Teach online courses. Here you put in the work to create it once, and you could sell it infinite amounts of time. To stay competitive, you’ll need to update the material. Plus, the best courses I’ve taken give you access to the course instructor, which lowers how “passive” this income may be.
If you are working full-time, try to explore some ideas now while you are working. Passive income type businesses are best built as “side hustles” while you have a more reliable income source to lean on.
Buy a Passive Income Stream Waterwheel
If you have more money than time, a shortcut to passive income is buying either a rental property, a business, or a piece of a business.
For example, you could avoid the work of building a business by instead buying an online business asset, one that was already throwing off an income stream. However, you would still need to run and maintain the business, and the income would probably be active per IRS rules.
Or you could buy into a business someone else was running and do nothing more than collect income. Here’s where passive income to you may match the IRS definition of passive income.
According to the IRS, there are two kinds of passive activities.
- “Trade or business activities in which you don’t materially participate during the year.” For example, a limited partnership. Here you invest money, but not time or effort, which means you don’t “materially participate” in the business.
- “Rental activities, even if you do materially participate in them, unless you’re a real estate professional.”
If you own rental properties and earn income from them, this can be a passive activity per the IRS. However, whether this is passive income FOR YOU depends on the time you need to put into it. There’s a big difference in the amount of work between doing it all yourself or paying a management company to deal with renters and perform maintenance and repairs.
Buying real estate and living off the rental payments is a popular path to achieve financial independence.
Buying a business or a piece of one isn’t as common because it concentrates a lot of risk into one investment. So let’s move on to a more common form of passive income that powers financial independence—portfolio income.
What is Portfolio Income?
Portfolio income is truly passive income. Although there are some exceptions (like day trading), it requires minimal work.
If you’re a DIY investor, there is the effort to choose and manage the assets that generate portfolio income. If you hire someone to help you, you’ll need to spend a bit of time and effort selecting that person.
For most people, the time spent on portfolio income is a tiny fraction of the time spent generating active income.
When your portfolio pays for all your living expenses, that’s the very definition of financial independence. It’s when your money earns money, or to use the common phrase “your money works for you.”
It’s the source of compound interest, the rocket fuel that powers the ability to retire from active work.
Portfolio income is classic retirement income.
Buy a Passive Income Stream Waterwheel System
So how do you generate portfolio income? You buy “paper assets,” which produce three primary forms of income:
- Interest. You’re the lender, and you’re paid interest based on your investment. Examples range from safe bank certificates of deposit (CDs) to bonds of varying risk levels to the risky realm of peer-to-peer lending.
- Stock dividends. Dividends are paid when a company shares a portion of its income with shareholders. Not all companies pay out dividends, but some do generously.
- Capital gains or capital appreciation. These are the gains you realize when you sell an asset for a profit. Typically, from stock appreciation, like when a stock you bought for $10 is now worth $50, netting you $40 when you sell it.
Note, when you buy stocks, you are purchasing a piece of a business. There is overlap between portfolio and passive income here, but with stocks, you typically own only a tiny fraction of a company.
A significant benefit of portfolio income is that it isn’t subject to Social Security or Medicare taxes. Also, qualified dividends and long-term capital gains are taxed at a lower rate than earned income.
Portfolio income is the gold standard for passive income.
Active vs. Passive Income for Time Freedom
Understanding the difference between active vs. passive income is essential when designing a financial plan to fund your intentional life.
Passive income is the key to time freedom. Moving from active income to passive income gives you options for how to spend your time.
Building passive income streams is how you achieve financial independence. The formula of financial independence is based on it—financial freedom is when passive income pays for your living expenses.
Take Out the “Versus” in Active vs. Passive Income
Think in terms of multiple streams of income to diversify your income. Instead of depending on only one income source, create as many as possible. The more you have, the better you can withstand hits to one of them.
This is especially important if you want to retire early.
Portfolio income is terrific, but you first need to earn money, build savings into your budget, then invest it. It can take decades to build a portfolio large enough to live off.
In 2021, safe or lower-risk paper assets pay almost nothing in income. The stock market can provide great returns, but you need to be willing to ride out the shorter-term volatility. See March 2020 for an example of the rough ride stocks offer in the short-term!
It’s better to take control by diversifying your income sources. Forge a mix of active and passive sources. Having multiple streams of income gives you options.
Instead of planning to rely only on portfolio income in the future, consider building a business that contains a mix of active and passive income. This can help you bulletproof your retirement plans. It can help you bridge the gap between where you are now and where you want to be.
Plus, having a fat portfolio to pay your living expenses is a great goal, but what do you do after that? Working can be a healthy part of life. For example, part-time work, exercising skills you enjoy could be an ideal lifestyle for many.
Now that you understand the difference between active and passive income, you could blend the two. For example, you could design a freelance writing business with active income from working with clients and passive income from a blog.
Consider building a tiny business that gives you flexibility. It’s limited only to your skills and imagination.
Start Making the Transition from Active To Passive Income
At the beginning of our journey towards financial independence, we have little choice. We can’t decide between active vs. passive income. It’s decided for us—active income is the starting point for most.
But don’t stay there. Do everything you can to build passive income streams now.
Start by funding your retirement accounts, the ones that will provide portfolio income. Use your active income to buy pieces of the “waterwheel system” that can eventually support you. Portfolio income is truly passive income, but it can take decades to build for most of us.
Then, consider starting a tiny business powered by passive income streams. Yes, it will take time and effort, but you can build it slowly, over time.
To keep yourself motivated through the tough slog, visualize the idea of the waterwheel turning and see the money flowing into your bank account.
Then feel the delicious sense of freedom you’ll have when you can do what you want with your time.