You may see many people on the internet talking about passive income. What’s not to be desired about earning money while you are doing other things? It’s a hot topic that deserves to be understood since there are a lot of misconceptions about what it is and how it is obtained.
What is Passive Income?
To answer this question, you must understand the different types of income available to you: earned income, portfolio income, and passive income. However, many people today refer to passive income as simply income you are not actively working for. This can cause a lot of confusion come tax time so let’s break it down.
Even though you may have a side business driving for Uber while on your way to work, you are still actively participating in the generation of the income each time. These “gigs” are great for earning extra seed money to then invest in passive income assets! This, along with your full or part time job, is considered earned income.
If you are employed or self-employed, there is a good chance this money is considered earned income. In the US, this is the highest taxed income. Earned income is also used to determine if you can invest in a Roth IRA.
This is income that is derived from your ownership in stocks, fixed income, and mutual funds in the form of dividends, interest, and capital gains. Why this income is desirable compared to earned income is that you are not subject to various tax and health benefit withholdings. Notice on your next paycheck all the little deductions made.
Portfolio income is free from those deductions and is potentially tax free given the account it is held in and if you have any capital losses to offset the capital gains. Otherwise, your qualified dividends and long-term capital gains will be taxed, but at a reduced rate compared to earned income, interest, and ordinary dividends.
For US tax purposes, passive income is defined as income derived from rental property, limited partnership (private investments), and direct business ownership as an angel investor (not actively managing day to day operations). This is really only important for you to understand if you are ambitious about taking advantage of incentives your government has for these investment activities.
How does this information help me grow my passive income?
Beginnerspassiveincome.com was created to help investors understand all the options you have for buying, borrowing, or building passive income streams, regardless of how it is classified by tax accountants. Our site is based on teaching you how to generate and manage your money through income producing assets and not a job.
However, it is important to understand expectations for each income stream before you spend your limited time and money on it. Imagine if you thought flipping houses or being a real estate agent was a passive income stream? You would either be upset about all the education and work that you needed to put in to buying and selling houses or end up with a tax bill you are not ready to pay since those are actually considered earned income or taxed as such.
You may talk to someone who makes “passive” money in their spare time driving for Doordash or buying and selling items on Facebook. These are called gigs or side hustles and should not be mistaken for passive income without building up some kind of business that you can step away from and still receive business ownership income (passive income). By understanding what assets are truly passive can you begin to assess your own situation and design which income stream makes the most sense for you to begin growing.
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