Passive income is money earned with little to no ongoing effort, unlike traditional earned income that requires active work. It typically comes from leveraging assets such as property, investments or specialized knowledge to generate revenue over time. Whether it’s rental income from real estate, dividends from stocks or earnings from digital products and advertisements, passive income provides a way to build wealth and financial stability without being directly tied to a job.
If you’re looking to increase your investment income, a financial advisor can help.
Passive Income Vs. Earned Income
Income can generally be categorized into two main types: earned income and passive income. Earned income refers to money received in exchange for active work, such as salaries, wages or freelance payments. It requires continuous effort, meaning that if a person stops working, the income stream typically stops as well. This type of income is the most common and is often associated with traditional employment, where individuals trade time and skills for a paycheck. Taxes on earned income can be relatively high due to payroll taxes and income tax brackets.
On the other hand, passive income is money earned with little to no direct involvement on an ongoing basis. Examples include rental income, dividends from investments, royalties from books or music, and profits from businesses that do not require day-to-day operations by the owner. While passive income often requires an initial investment of time, money or resources, it has the potential to generate earnings over time with minimal ongoing effort.
The key difference between these two types of income lies in sustainability and effort. Earned income provides immediate and predictable earnings but requires continuous labor, whereas passive income offers financial independence but often demands upfront investment and patience. Many financially successful individuals aim to build multiple streams of passive income to reduce their reliance on earned income and create long-term wealth.
What Is Passive Income?
As defined by the IRS, passive income is when you make money from an enterprise where you’re not materially involved. This means you’re the silent partner, the investor, the person who is not running the show.
The IRS gives more specific limitations as to what “material participation” means. For one, you must work at least 500 hours in a year on the project or more than 100 hours when no one else works more than you. Or if you contributed almost all of the work on a project, it’s considered material involvement. Likewise, if your work in multiple significant participation activities (SPAs), combined, exceeds 500 hours, it counts as material participation. There are a few more criteria that would qualify a project as material. You only need to meet one to qualify.
As mentioned earlier, passive income differs from earned income and portfolio income. Earned income is wages, salary, tips, bonuses, commissions and net gains from self-employment. Portfolio income, on the other hand, is dividends, interest and capital gains. Significantly, passive and portfolio income are not subject to Social Security or Medicare taxes. They’re also taxed at different rates than income taxes.
There are a ton of ways to make passive income. As we said above, not all methods are entirely passive. Let’s take a look at the top ways to make passive income based on their levels of involvement.
Tax Implications of Passive Income
The tax treatment of passive income differs from that of earned income, often leading to different tax rates and regulations depending on the type of passive income. Generally, passive income is subject to capital gains tax, dividend tax, or rental income tax, depending on how it is generated.
For example, long-term capital gains from investments are typically taxed at lower rates than ordinary earned income, while qualified dividends may also benefit from preferential tax rates. However, rental income and other forms of passive earnings may be subject to standard income tax rates, with deductions available for expenses like property maintenance and depreciation.
Passive Income Sources With Low Involvement
Passive income that takes next-to-no involvement is the dream. That’s probably a large part of the appeal of robo-advisors. You fund the investment account, and an algorithm keeps your balance growing.
Of course, you can also hire a person to manage your investments. Human financial advisors typically cost more than a robo-advisor, but they can take unusual conditions, like a market sell-off, into account in a way that a computer may not. They also can listen, answer questions and provide guidance. You can use our free matching tool for help finding a financial advisor.
If you want to do the investing yourself, dividend stocks are a popular source of passive income. Of course, you’ll have to do your research and pay attention to the market, but assuming you find great dividend stocks, you won’t have to do much more. If you have a lower tolerance for risk, you could simply open a high-yield savings account or build a CD ladder. Again, you’ll have to do your research to find the right ones and keep an eye on the accounts to make it a successful source of income.
Passive Income Sources With Medium Involvement
For medium-involvement passive income, you could buy real estate and rent it out. Similarly, you could buy a business and then have someone else run it for you. Both examples involve research, work and money at the start. But after the initial investment, you’re mostly just depositing checks.
If you have anything in excess, like house space, cars or even your driveway, you can consider renting them out. Since you already own these items, you wouldn’t have to go around buying new things. Simply list these things somewhere, like a room on Airbnb, to get started. You’ll probably have to put in some time and money for the upkeep, but otherwise, it’s a mostly passive venture.
If you have expertise in something, you could create an online course. Sites like Udemy can help you do this. It requires some work to create the course, but once it’s available online, you get paid as people sign up to take it.
Passive Income Sources With High Involvement
One way to make passive income with more involvement is to write and publish an e-book. Got some knowledge or a great story idea you’ve been itching to share? Put it all in a book and sell it online! If all goes well, you could be raking in the royalties for years to come. Of course, there’s some considerable work involved in writing, publishing and selling a book. However, the advent of self-publishing e-books makes this a considerably easier option than it used to be.
Of course, a book isn’t the only way to get your thoughts to the world nowadays. You could also start a blog, website or YouTube channel to earn some passive income. Besides the creation of your website, videos and content, sharing your ideas and advice online seems pretty passive. However, it will take a lot of work on your part and time to gain readers, followers and then paid advertisers. You’ll need to make your content marketable and appealing. That way you continue to gain followers, advertisers and money.
Further playing off of your talents and ideas, you can easily sell products online nowadays, too. Find companies where you can sell your musical talents for jingles. Look for companies that need freelance designers. While you can earn passive income through these royalties, again, it will take time and work to produce your craft, whatever it may be.
If you happen to be technologically inclined, you could consider making a smartphone app. This isn’t easy, nor a passive project. However, once you complete the right app, you could see a steady passive income for many years.
Bottom Line
Overall, generating passive income only has an upside. The idea is to make money while you go about the rest of your life, either working at your day job or, if your passive income is large enough, doing whatever you love. Disruptive companies that allow people to, say, rent out their rooms or sell their online courses have made passive income more possible to more people. YouTube and other social media platforms have created a whole profession of social influencers who earn passive income from advertising sales.
Tips for Increasing Investment Income
- Keep costs down. When choosing mutual funds, look at their expense ratios. Generally, you want them lower than 1%. If you’re going to buy exchange-traded funds (ETFs) or individual stocks, make your trades online. Many brokerages, including Charles Schwab, E-Trade and TD Ameritrade offer no-commission online trades.
- Don’t go it alone. A financial advisor who has a good (and long) track record can help you maximize returns within your comfort level for risk. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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