There are two types of income: active income vs passive income. Passive income sounds great, but does it really exists? Many people are still unsure of the difference between the two. And, most importantly, how can we generate a passive income source?
Key Takeaways
- Active income is when you earn only when you are actively working. You are trading your time for money. Examples: salary from your full-time job, part-time job, freelancing, or sales commission.
- Passive income is when you earn income even when you are not doing anything (even when you sleep). Examples: royalties, dividends, stock price appreciation, and rental incomes.
- One of the most common ways to build wealth is to convert your active income into passive income. Use the income you earn from your active income to invest in assets that generate passive income, such as real estate, stocks, and bonds.
Active Income
Active income is the earning you generate from active participation in work-related activities, such as working a full-time job, part-time job, freelancing, or sales commissions. Even if you actively run your own business, the earning is still considered active income. The most straightforward way to check whether an income source is an active income vs passive income is whether you will still get that income if you do nothing (even sleeping). For active income, there is no income if there is no productivity.
Active income is what most people start with as they enter the workforce. But this is rarely the end goal. If active income sounds acceptable to you, let us ask you this question: Do you think you can still work when you are older, ex 70 years old? If you think so, would employers still hire you if they can hire a much younger person who can be much more productive and knowledgeable than you? At some point in our life, we need to retire, and the key to a stress-free retirement is to have a good source of passive income.
Passive Income
Passive income is the earning you get even when you are not doing anything. Yes, nothing, even when you sleep or are on vacation all year. And yes, passive income really exists. Passive income is usually generated by owning income-producing assets which do not require active participation from the investors.
Some common examples of passive income are interest payout from bonds, dividend payouts, stock price appreciation, rental income, royalties, and silent partners in a partnership.
The above examples do not require your active participation to receive the income. You will still receive the income regardless of what you do, even when you travel for the whole year enjoying your life.
Those in Singapore may have realized that many of these passive income sources are tax-free. Not only do you not have to do anything, you don’t even have to pay taxes.
How to Generate Passive Income?
Well, passive income is magical, isn’t it? So how do we generate this passive income so we can still earn even when we sleep?
The easiest way is to convert active income into passive income. Use your active income to acquire good-quality income-producing assets. As these assets generate passive income, use these additional incomes from your passive source to acquire even more assets. Rinse and repeat!
There you go, that’s the ‘holy grail’ of wealth building. Yes, it may take some time to build these passive income sources, but by reinvesting your passive income to acquire more income-generating assets, you are creating a compounding effect on your income. This compounding effect will make your income grow faster and faster as you keep doing it over time. This is one of the most common ways investors grow their wealth over time.
Summary
The main characteristic that differentiates active income vs passive income is whether or not you will still earn the income regardless of what you do. If you only earn when you have to be productive, that’s active income. If you earn even when you do nothing, that’s passive income.
| Active Income | Passive Income | |
|---|---|---|
| Characteristics | The income you earn only when actively participating in work-related activity. As soon as you stop participating, your income stops. | The income you earn even when you do nothing. |
| Taxation | Taxable just like a regular personal income. | Tax-free or eligible for tax deductions. |
| Timeline | Quick, most people can get a regular job. | Longer time to accumulate, usually through acquiring good-quality income-producing assets. |
| Impact | You trade your time for this active income. | You can do whatever you want, even sleep or vacation, and still earn passive income. |
There are many ways to build wealth, but one of the easiest for most people is using their active income to acquire high-quality assets and reinvest the additional income generated to acquire even more assets. If you keep doing it over time, you are on the right path to building wealth. Happy investing!
