Understanding Differences: Earned vs Passive vs Investment Income

In the world of personal finance, understanding the different types of income is essential for developing a comprehensive financial strategy.

Three primary types of income exist:

• earned income (active income)
• passive income
• investment income

Each type of income offers distinct opportunities and challenges as individuals work to achieve their financial goals.

Earned income is money made from active participation in a job or business (i.e, dentist, engineer, nurse). This includes wages, salaries, tips, and commissions, among other types of income generated by directly working.

Passive income, on the other hand, is money earned without actively investing time or effort into generating it. Examples of passive income include rental property income, royalties from intellectual property, or dividends from stocks.

Investment income is money received from investments, such as capital gains, interest, dividends, and distributions from stocks and mutual funds.

Key Takeaways

• Earned income is generated by active participation in a job or business, while passive income is earned without direct effort.
• Investment income results from investing in various financial instruments like stocks, bonds, or mutual funds.
• Understanding the differences between earned, passive, and investment income assists individuals in creating a comprehensive financial strategy.

Join the Passive Investors Circle

What Is Earned Income?

Active Income

Earned income refers to any income received from a job or self-employment, meaning it’s money earned through active participation in work. The key aspect of earned income is that it requires an individual’s direct effort to generate revenue. It includes wages, salary, tips, bonuses, and commissions.

As a periodontist, I must trade time treating patients to receive active income. 

Full-Time and Part-Time Job

Earned income can be earned through both full-time and part-time jobs. Full-time jobs usually require around 40 hours per week, while part-time jobs may have varying hours, typically less than 40 hours per week. Regardless of the nature of the employment, income derived from these job positions is considered earned income and taxed accordingly (which we’ll get into shortly).

Self-Employment Income

Self-employment income includes money earned from running a business, working as an independent contractor, or freelancing. In these cases, individuals are responsible for paying all income taxes, as well as self-employment taxes, which include social security and Medicare contributions.

Social Security Benefits

While social security benefits may be considered as a source of income, they’re not classified as earned income. These benefits are paid out to eligible recipients based on their work history, with contributions made to the social security system over their working years. Social security benefits are only taxed when the recipient’s total income exceeds certain thresholds.

Medicare Taxes

Medicare taxes are paid on earned income by both employees and their employers. In the case of self-employed individuals, they’re responsible for paying the full Medicare tax amount.

These taxes and social security taxes contribute to the payroll tax deductions employees see in their wage statements.

It’s worth noting that not all types of income are subject to these taxes, but earned income is.

Income Tax Liability

Earned income typically has the highest tax liability compared to passive and investment income. This is because it is subject to federal income tax, state and local taxes when applicable, and payroll taxes.

The effective tax rate on earned income is also influenced by an individual’s filing status, deductions, and exemptions, which can alter the amount of tax owed each year.

---

---

Exploring Passive Income

Rental Income

Passive income is money earned without actively investing time in generating the income. One common source of passive income is rental properties.

Rental income is generated when a property owner rents out their property to tenants, and they receive monthly payments without actively managing the property. Hiring a property management company can help reduce the amount of active work required, making this income more passive.

Online Course and YouTube Channel

Another way to generate passive income is through creating online courses or a YouTube channel. Creators can develop courses or videos that teach a specific skill or topic and then sell access to these materials.

While the initial creation and marketing of the content may require effort, the income generated once the course or channel is established becomes passive as students and viewers continue to purchase and consume the content without additional involvement from the creator.

You are subscribed to my YT channel, right?

Dividend Stocks

Dividend stocks are another popular source of passive income. When an investor owns stocks that pay regular dividends, they receive a portion of the company’s earnings without actively working for the company.

By investing in a diversified portfolio of dividend-paying stocks, investors can collect a constant stream of income without needing to sell their shares or monitor their investments daily.

Affiliate Marketing

Affiliate marketing is a way to generate passive income by promoting products or services from other companies. In this model, you partner with a company and earn a commission for each sale your referrals generate.

By sharing affiliate links through your website, social media channels, or blog, you can earn passive income as users click on the links and make purchases without your ongoing involvement in promoting the product or service.

What About Investment Income?

Investment income is the money generated from stocks, bonds, and real estate investments. It differs from earned income, which is money earned through work, and passive income, which is money earned without active effort. 

Interest Income

Interest income is generated when an investor lends money to an entity, such as a bank or a company, through instruments like bonds or certificates of deposit (CDs). The borrower pays interest to the lender as compensation for the loan. Examples of interest income include:

• Savings accounts and CDs
• Bonds, such as government bonds, corporate bonds, and municipal bonds
• Peer-to-peer lending

Long-Term Capital Gains

Long-term capital gains are profits from selling an investment held for more than a year. These gains are typically taxed at a lower rate than ordinary income. Examples of investments that can generate long-term capital gains include:

• Stocks
• Real estate
• Art or collectibles

Portfolio Income and Mutual Funds

Portfolio income refers to the combination of interest, dividends, and capital gains that investors receive from their investment portfolios. Mutual funds are a common way for individuals to diversify their portfolios by combining a variety of investments, such as stocks and bonds, into a single investment vehicle.

These funds generate different types of investment income, which may include:

• Dividends from stocks held in the fund
• Interest from bonds in the fund
• Capital gains from the sale of investments within the fund

Real Estate Investment Trusts

A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate properties. These trusts allow investors to gain exposure to real estate without directly purchasing properties. REITs generate investment income in the form of:

• Dividends paid to shareholders from rental income or profits from property sales
• Capital gains on the sale of properties within the trust

Private Equity

Private equity investments involve investing in private companies or taking public companies private through buyouts. These investments are typically accessible only to institutional investors and accredited individuals due to their high risk and illiquidity.

Want to learn more about becoming an accredited investor? Check out this video:

Investment income from private equity can come in several forms, such as:

• Dividends paid by privately-held companies
• Capital gains from selling a stake in the company
• Proceeds from the eventual sale or public offering of the company

Tax Implications and Tax Deductions

Earned income, passive income, and investment income each have their own distinct tax implications as well as deductions that apply to them. 

Earned Income comprises wages, salaries, tips, bonuses, and commissions resulting from active employment or self-employment. Taxable earned income is generally subject to ordinary income tax rates.

As a periodontist, I thought this was the ONLY way I’d earn money throughout my career. But the more I became involved with our finances, the MORE I realized that there were multiple other income sources with lower tax implications which we’ll get into shortly.

Individuals who earn active income can take advantage of various tax deductions, such as retirement account contributions for IRA or Roth IRA, as well as other deductions related to work expenses depending on the nature of their job.

Passive Income originates from sources such as rental properties, royalties, and passive partnership income, which do not involve active participation in a business. Passive income is also subject to ordinary income tax rates.

The Internal Revenue Service (IRS) allows taxpayers to offset losses from passive activities against income generated from the same activities, such as rental property losses. However, there are strict regulations and limitations on the deductions that can be claimed against losses from passive activities.

Investment Income is generated from investments, like interest, dividends, and capital gains from selling securities or other assets. Investment income may be taxed differently based on the type of income. For example, qualified dividends and long-term capital gains are typically subject to lower tax rates than ordinary income.

Also, certain investment expenses or interest payments on loans used to purchase investments may also be tax deductible.

Types of Investment Income and Strategies

Active Real Estate Investors

Active real estate investors actively buy, manage, and sell properties as a part of their investment strategy. This type of investment income is earned from capital gains when the property is sold, and rental income is generated while owning the property.

Active real estate investors are hands-on, often completing repairs and managing tenants themselves, making this an earned income source.

Passive Real Estate Investors

Unlike active investors, passive real estate investors do not directly manage property. Instead, they invest in real estate syndications, REITs or delegate property management tasks to others.

This type of investment income is passive and comes from distributions from syndications, dividends paid by REITs or rental income distributed to limited partnership stakeholders.

Bank Account

Bank accounts, such as savings accounts and money market accounts, provide a secure way to invest funds and generate interest income. This form of investment income is passive, as it accrues on deposited funds without active management from the account holder.

The interest rates on these accounts vary depending on market conditions and types of accounts, making them a flexible and low-risk investment option.

Exchange Commission

The exchange commission is essential in managing investments and ensuring fair trading practices. They are primarily responsible for regulating securities markets, protecting investors, and maintaining market stability.

Their role indirectly affects investors’ ability to generate investment incomes through the safe and efficient functioning of securities markets. In this context, they are relevant in facilitating the overall investment landscape for individuals and institutions seeking various investment income types.

Additional Considerations for Income Generation

Material Participation

When generating income, the level of involvement in an activity plays a crucial role. Material participation refers to the degree to which an individual actively participates in a trade or business. This is particularly important for classification as earned income.

Someone materially participating in a business is generally subject to self-employment tax on income derived from the activity. In contrast, those not materially participating may enjoy tax benefits associated with passive income.

Net Investment Income Tax

Investment income can be subject to the Net Investment Income Tax (NIIT) for some high-income individuals. The NIIT is an additional 3.8% tax on certain investment income, such as interest, dividends, and capital gains.

It’s important to consider the impact of the NIIT when generating investment income, as it could affect the overall return on investment. Proper tax planning and strategies can help mitigate the impact of the NIIT on investment income.

Limited Partnership

A limited partnership (LP) is a business structure that allows passive income generation for limited partners while the general partner manages the business. Limited partners generally enjoy liability protection and can receive income without actively participating in business operations.

This makes LPs an attractive option for those seeking passive income sources. However, it is essential to understand the risks and responsibilities associated with limited partnership investments before committing capital.

Rental Real Estate

Rental real estate is a common source of passive income for many investors. By owning and managing rental properties, individuals can generate a consistent income stream without actively participating in a trade or business.

However, rental real estate may involve considerable initial investment, ongoing maintenance, and management responsibilities. In some cases, rental real estate can qualify as active income, depending on the owner’s level of involvement. 

Challenges and Opportunities in Income Generation

Challenges and Opportunities	Description
Financial Decisions	Individuals need to make important financial decisions that impact the types of income they receive. For example, choosing investments wisely can result in passive income, whereas switching jobs or starting a business can impact earned income.
Amount of Time	Earned income typically requires the most time commitment, as it involves active work regularly. Passive income streams may initially require time and effort, but the ongoing time commitment can be substantially lower. Investment income typically occupies a middle ground, where the time spent on research and management can vary depending on the investor’s approach.
Social Media Platforms	Social media platforms allow individuals to create and monetize content, leveraging advertising, sponsored posts, or affiliate marketing strategies. Depending on the success of their content, they may secure a combination of earned, passive, and investment income.
Short Term and Long Term	Short-term income may not provide the sustained financial security that long-term income can offer. However, short-term income generation strategies can provide a boost in earnings or supplement other income streams. Long-term income generation strategies, particularly those focused on passive or investment income, focus on creating sustainable, long-lasting income streams that can contribute to long-term financial security.

Conclusion

In summary, earned, passive, and investment income are three distinct types of income individuals can generate. Earned income refers to money earned through active work, such as wages, salaries, tips, and commissions. On the other hand, passive income is generated without the direct involvement of the individual, primarily through rental properties, royalties, and limited partnerships.

Investment income comes from the increase in value or profits earned from financial investments, such as dividends, interest, and capital gains from stock and asset sales. While each of these income sources has its own unique characteristics and tax implications, diversifying one’s income stream through a combination of earned, passive, and investment income can contribute to long-term financial stability and growth.

By understanding the nuances between these types of income, individuals can better assess their financial situation and devise an appropriate strategy to maximize their overall income. It is crucial to consider the pros and cons of each income type to ensure a balance that aligns with one’s financial goals and risk tolerance.

Ultimately, a well-rounded approach to generating income, incorporating earned, passive, and investment sources, can help individuals achieve a more secure and financially independent future.

Frequently Asked Questions

How do earned income and passive income differ?

Earned income includes money from active work, such as wages, salary, tips, and commissions. Passive income, on the other hand, is money earned without actively investing time, such as rental income, royalties, and income from limited partnerships.

What are some examples of investment income?

Investment income, also known as portfolio income, includes interest on savings accounts, dividends from stocks or mutual funds, and capital gains from the sale of investments such as stocks, bonds, or real estate.

Are investment income and passive income taxed similarly?

Investment income and passive income are often taxed differently than earned income. Investment income may be taxed at a lower capital gains tax rate, while passive income may be subject to self-employment taxes or unique rules for specific sources of income like rental property.

How do the tax rates for earned income compare to investment income?

Earned income is usually subject to federal and state income tax rates, Social Security and Medicare taxes. Investment income, particularly long-term capital gains, is often taxed at a lower rate than earned income. The exact tax rates depend on an individual’s tax bracket and the holding period of the investment.

Is portfolio income considered a type of passive income?

Portfolio income is not considered a type of passive income by the Internal Revenue Service (IRS). Passive income generally refers to income earned without active involvement, while portfolio income refers specifically to income derived from investments such as interest, dividends, or capital gains.

What are common sources of passive income?

Common sources of passive income include rental properties, royalties from intellectual property or creative works, income from limited partnerships, and earnings from businesses where the owner is not actively involved in the day-to-day operations. Passive income can also include income from investments, like dividends from stocks, though the IRS distinguishes it from portfolio income.

Join the Passive Investors Circle