Non-passive income, also known as active or earned income, refers to the money that you earn through your active efforts, typically by trading your time and expertise for compensation. This is the inverse of passive income, which is earned with minimal effort or active involvement. However you earn your income, a financial advisor can help you manage your money and pick investments aligned with your financial goals.
How Non-Passive Income Works
Non-passive income can be derived from various sources. Wages, salaries, tips, bonuses, commissions and self-employment income are all examples. Each source represents a different form of active involvement, whether it’s a traditional job, a freelance gig, or a personal business venture.
Here’s a look at various types of non-passive income:
- Employment income: Your salary or wages from a job, where you trade your time and skills for payment. This is the most common form of non-passive income for many individuals.
- Self-employment income: If you run your own business or work as a freelancer or consultant, the income you generate falls into this category. It requires active involvement in your business operations.
- Business profits: If you own and actively manage a business, the profits generated are considered non-passive income. This includes income from partnerships, sole proprietorships, and LLCs where you play an active role.
- Professional services: Income earned by professionals like doctors, lawyers, or consultants for their expertise and services.
What Are Non-Passive Losses?
Non-passive losses, also known as active losses, refer to a specific type of tax deduction that primarily applies to individuals who are actively involved in a business or investment activity. These losses are distinct from passive losses, which are incurred from passive activities like rental real estate or limited partnership interests.
Non-passive losses can offset other sources of income, such as wages, interest and dividends, to reduce an individual’s overall tax liability. However, to claim these losses, you must meet certain criteria set by the Internal Revenue Service (IRS).
To qualify for non-passive loss deductions, you generally need to play a significant role in the day-to-day operations or management decisions of a business or investment activity. Additionally, your participation should meet the IRS’s definition of material participation.
Examples of Non-Passive Income
To gain a clearer understanding of non-passive income, here are four common examples:
Wages and Salary
Perhaps the most common source of non-passive income is the income earned through regular employment. When you work a job, your paycheck is a direct result of the hours you put in and the skills you bring to the table. Your salary or hourly wage is a prime example of non-passive income, as it requires ongoing work to sustain.
Investment Income and Dividends
Investing in stocks and bonds can yield non-passive income through various means. For instance, when you invest in a company that pays an ordinary dividend, you receive a portion of the company’s profits regularly. While this may feel like passive income, ordinary dividends are treated that way by the IRS. Investment income and dividends are considered non-passive streams for tax purposes because they rely on your investment decisions and involvement.
Retirement income, which often includes pensions and annuities, is another form of non-passive income. These funds are built up during your working years and are paid out to you during retirement.
Social Security benefits are a vital component of non-passive income for many retirees. Workers contribute to the Social Security system throughout their careers, and when they reach retirement age, they become eligible to receive regular payments. While you don’t actively work to earn Social Security benefits in retirement, your contributions during your working years support this form of non-passive income.
Non-Passive vs. Passive Income
Comparing passive and non-passive income is essential to understanding their different financial implications. While non-passive income requires active involvement, passive income is earned from ventures in which the person is not actively involved.
Income from rental properties or limited partnerships can all be considered forms of passive income. These streams will continue to flow even though you’re not actively working on them. They can provide financial stability and potentially lead to financial independence.
Understanding non-passive income, its sources and implications can significantly impact your financial decisions and future planning. It allows you to better anticipate tax liabilities and potential income sources, aiding in more informed decisions, and ultimately, a more secure financial future.
Tips for Managing Your Income
- Having the right balance of stocks, bonds and cash can help you lower risk and align your investments with your financial goals. SmartAsset’s free asset allocation calculator can recommend a mix that’s potentially suitable for your risk tolerance.
- A financial advisor can help you manage your money and make important decisions. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three 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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