Active income vs passive income – what’s the difference?
Maybe you’re working hard trying to turn your side hustle into your main gig, or maybe you’ve already taken the leap and set yourself up as your own boss. Either way, you’re probably really focused on INCOME…making money and keeping it in your pocket is the name of the game, right? And when it comes to income earned, you may feel like money is money, but the IRS doesn’t always agree. Today, we’re going to talk about the differences between active income and passive income, and why the distinction matters to you.
What Is Active Income?
Active income is money you made by directly taking action. Working your 9-5 job, earning tips as a server at a restaurant, or delivering for UberEats…all of those activities will earn you money, and all of that money is considered active income.
Unless you inherited a tremendous amount of wealth or won the lottery, you almost certainly will need to pursue active income to pay the bills and save for your future. If you’re successful and/or frugal, you may be able to invest some of your active income into something that generates passive income in the future.
What Is Passive Income?
Passive income can be a bit more confusing than active income, because the IRS has a long list of qualifiers that can be difficult to wade through. At the most basic level, the IRS guidelines for passive activities are identify two kinds of passive activities:
- Trade or business activities in which you don’t materially participate during the year
- All rental activities for non-real estate professionals—even if you do materially participate in them.
The important phrase to understand here is “materially participate.” How do you know what qualifies as “materially participating” and what doesn’t? The IRS says that generally, you are eligible to claim material participation if you participated in a business on a “regular, continuous, and substantial basis.” Still not sure? The IRS offers a list of seven tests (called, conveniently, the “material participation tests”) you can use to determine if you actively participated in generating specific income.
Material Participation Tests (source: IRS Publication 925):
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities under Recharacterization of Passive Income, later.
- You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
If you satisfy just one of the seven tests, your income is considered active.
Active Income Examples
Active income is the most common type of income in the US, and it is something that most of us earn. Whether you’re a salaried employee of a large corporation, an entrepreneur working for yourself full time to fulfill your dream, or anything in between, anything you actively participate in to make money makes that income active income.
Active income includes:
- Hourly wages
- Income from invoices as an independent contractor
- Sales commissions
Passive Income Examples
Defining passive income can get complicated and specific from person to person. We recommend you seek advice from a qualified tax professional if you want personalized advice for your unique situation. Below, we provide a few examples of income that could be considered passive by the IRS:
- Affiliate marketing income: High traffic websites that do not require regular content creation can earn you passive income if you add links to products or services or display ads.
- Rental income: Renting entire properties, a room in your home, or a garage or parking spot can all be considered passive income, as long as you are not a real estate professional.
- Licensing intellectual property: Royalties earned whenever someone purchases a book you’ve written, takes an online course you designed, or uses an app you created are considered passive income.
- Print-on-demand products: Uploading your designs to print-on-demand sites like Redbubble, Zazzle, or CafePress will earn you passive income every time someone purchases an item with your design.
- Cash back from a credit or debit card: If you are using a cash back credit card for everyday purchases, that rebate money you get may be classified as passive income.
How are active and passive income taxed?
Taxes on active income are fairly straightforward (as much as anything related to our complicated tax code can be straightforward!). You (or your tax pro) will calculate your appropriate tax bracket, apply any deductions, and you’ll pay the appropriate amount of federal income tax based on the amount of money you earned net of expenses. If you’ve paid taxes before on hourly or salaried wages, you’ve paid taxes on active income.
Taxes on passive income are more complicated, and they and can vary from situation to situation. Income that is passive for one person may be active for another, depending on how much time they spend on the activity that generates the income. And some types of passive income have their own unique rules when it comes to taxes (real estate and financial investments, for example. If you earn passive income, working with a certified accountant is a smart move that can help you avoid penalties and optimize your tax return.