For the most part, when we think of income, it falls into one of two categories: earned and passive. Understanding the differences between earned income and passive income can provide you with the knowledge needed to improve the way money moves through your personal economy, as well as build up the income diversity that will help protect you if you end up in an unexpected employment situation.
Earned Income vs Passive Income
This is income that is characterized by active actions designed to earn money. When you go to a traditional job, this is earned income. My writing is earned income. I actively perform tasks in order to get paid. When you are involved in owning your own business, you are earning active income. Most people get the bulk of their money by working for it. Whether you get paid per task, by the hour, or a flat annual salary, earned income is a way of life for the majority of society.
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For the most part, this is income that you don’t have to do active work for. However, it is important to note that few income sources are completely passive. Before you can start earning passive income, you usually have to do something to set the process in motion. You might have to fix up a rental property before you can start collecting the rent. If you want passive income from a web site, you have to build up the traffic and build revenue by finding advertisers or joining affiliate programs. Even passive income from investments requires that you research your options and make wise choices.
For the most part, passive income is characterized by the fact that once you get a system set up, you only have to perform occasional maintenance to keep the money flowing. There are few, if any, opportunities for 100% completely passive income. If you leave the rental property alone and don’t use a rental management company, the property will fall into disrepair. If you ignore your website for long enough it will eventually go stagnant and the passive income stream will stop.
How the IRS Views Your Income
The IRS views your income as three different categories: active, portfolio, and passive. It is important that you understand the distinctions so that your income is properly taxed. If you don’t understand how the IRS categorizes your income, you could pay too much tax. Or, you might pay too little — and face penalties if an audit catches the mistake.
- Active Income: This is income from wages, tips, and active business participation. For example, if you have a rental property and you run it as a business, pay for maintenance and upkeep, and offset some of your income from rent received, it is considered active business participation. This income will be taxed at your regular personal income tax rate.
- Portfolio Income: As you might imagine, portfolio income is the result of your investments. This income comes in the form of capital gains, dividends, and interest. Money you make from stocks, bonds, mutual funds, or other investments, is considered portfolio income. You can offset gains in portfolio income with losses. It is important to remember that, though you may see your dividends as passive income, the IRS classifies them as portfolio income, and you must follow those tax rules.
- Passive Income: The IRS is kind of vague about passive income, simply pointing out that it is money you receive that doesn’t come from business activities or wages, nor from dividends, interest, or capital gains. The IRS does not allow your passive losses to offset gains from portfolio income or active income.
It is a good idea to talk to a tax professional if you have different types of income. You will be sure that your income is properly classified, and that you are reporting everything correctly to Uncle Sam.
Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own personal finance blog: Planting Money Seeds.