Many of us have contemplated a life enriched by passive income — streams that earn as we sleep and travel. Passive income is crucial for early and standard retirement, bridging income gaps or supplementing Social Security when retiring before 401(k) eligibility. Explore the distinctions between earned income vs passive income for a comprehensive financial perspective
Yet, it's vital to understand the distinctions between how we view activities as passive in terms of time and effort and what the law deems as earned income vs passive income, considering tax and investment perspectives.
Erika Taught Me
- There are three types of income from a tax perspective: passive income, earned income, and investment income.
- Passive income is typically rental income (unless you’re a real estate professional), royalties earned from previous work, or income from partnerships where you’re not materially participating.
- Losses from passive income have important tax restrictions, but losses from earned income can be written off against other earned income such as wages.
- There are simple tests provided by the IRS to determine if income is earned or passive.
Distinguish Different Income Types
While there may seem some overlap in the definitions of different kinds of income streams, there are three distinct types of income: passive income, active or earned income, and portfolio or investment income.
Passive income
There are just two ways to generate passive income according to the IRS. These include:
- rental income, unless you’re a real estate professional (even if you materially participate in them)
- income from businesses in which you do not meaningfully participate during the tax year
Active income
Active income, also called earned income, includes all income from employment such as wages, salaries, tips, and other taxable compensation. It also includes net earnings from self-employment. Income from side hustles and businesses can fall under earned income based on meeting any one of a long list of tests. Importantly, if the activities pass any of these tests, then losses from these activities can reduce taxable income from other earned sources such as wages.
Portfolio income
Typically, portfolio income comprises earnings from investments, interest, and dividends. Taxation treats interest income from savings accounts, CDs, and money market funds as ordinary income. Capital gains, achieved by selling investments at a profit, might incur lower tax rates with a minimum one-year holding period.
While qualified dividends could face lower tax rates, ordinary dividends are subject to the same tax rate as wage income. Typically, qualified dividends are directly from U.S. companies with a required minimum holding period. Dividends passed through mutual funds and exchange-traded funds (ETFs) may be qualified or ordinary depending on how long the fund has held the stock and how long the investor has held the fund.
What is passive income?
From a time and energy standpoint, individuals might mistake passive income for portfolio income, assuming they still receive earnings without ongoing participation. From a tax perspective, there are only two types of passive income:
- Rental income, unless you’re a real estate professional, and
- Income from trade or business activities in which you do not materially participate during the year
Besides rental property income, examples of passive or unearned income may include:
- Royalties from a book created in previous years without recent updates
- Income from a course created in previous years without recent updates
- Affiliate revenue from an older blog
- Income from a business or partnership in which you do not materially participate; for example, investing in a restaurant and receiving a percentage of profits without actively participating in management or operations
Passive income is an important designation because net passive activity losses can generally only reduce taxable income from other passive activities, which would exclude earned income from wages. At the same time, while passive income is taxable, it is not subject to self-employment tax.
What is earned income?
Earned or active income comes from a variety of sources, including taxable compensation from employment and self-employment income from businesses where you have material participation. Examples include:
- Wage, tips, and salary income
- Income from an Etsy store that you operate by yourself
- Affiliate revenue from an active blog
- Income from a course launched this tax year
Importantly, losses from one source on this list can reduce taxable earnings for another source. For example, net business losses from your Etsy store may be able to reduce your taxable income from hourly wages or full-time employment.
Passive Vs. Earned Income: Tax differences
Several crucial tax variations exist between earned and passive income.
- Earned income is subject to either self-employment tax or Social Security and Medicare taxes if employed on W-2
- Losses from passive income streams can only be deducted from passive activity gains, with limited exceptions for real estate losses
- Losses from earned activities can reduce taxable income from other earned activities including salary and wage income
- Interest, short-term capital gains, and ordinary dividends from portfolio income incur the same taxation as wages.
- Long-term capital gains and qualified dividends are taxed at reduced rates
Related: Active vs Passive investing: Which strategy makes you rich
Active and Passive Income: Investment differences
The main investment difference between active income and passive income is that passive income cannot be the basis for contributions to tax-preferred accounts such as an IRA or 401(k).
- Contributions to an IRA must come from earned income; passive income cannot form a basis for such contributions
- Contributions to a solo 401(k) are limited to 25% of self-employment income
- You can utilize both earned and passive income for investments in taxable brokerage accounts.
How to differentiate between active and passive income
The key distinction between passive income and earned or active income is whether you had material participation. The IRS publishes a number of tests such that passing even one demonstrates material participation in the relevant tax year and therefore classifies the income as earned.
These include but are not limited to:
You participated in the activity for more than 500 hours. Regardless of how many other individuals contributed to the business or how many hours they participated, if you participated for at least 500 hours in the year, then you have earned active income from this business activity.
Your participation in the activity for the tax year was substantially all of the participation in the activity of all individuals (including individuals who didn’t own any interest in the activity) for the year. If you’re the only “employee” for the business activity, and there are no other employees or volunteers with meaningful hours, then you have earned active income from this business.
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. If other individuals are participating in the business activities, but you worked at least as many hours as anyone else AND worked at least 100 hours during the year, then you have earned active income from this business.
You materially participated in the activity for any five (consecutive or not) of the 10 years immediately preceding the tax year. Not all tests are for the current tax year. Passing a material participation test in 5 of the last 10 years designates the business income as active.
Scenarios: Active vs. Passive income
- You spend five hours per week running a blog with no additional support and revenue from affiliate links. Active income
- You spend five hours per week supporting a multi-member LLC, where other members spend considerably more time. Passive income
- You spend 10 hours per week supporting a multi-member LLC, where other members spend considerably more time. Active income
- You wrote a book three years ago and published it online. You’ve done no additional work but earned royalty payments this year. Passive income
The tax implications of earned vs. passive income can be large. If you are considering a side hustle or receiving business income or facing losses, we recommend discussing your situation with a licensed CPA, at least during the first year to make sure your income is appropriately classified and that you are maximizing your eligible deductions.
FAQs
Is real estate rental property income considered passive?
This is true even when you pass tests for material participation, such as 500 hours of participation in business activities.
In some cases, you may be eligible to deduct up to $25,000 of real estate losses if you were an active participant. However, this begins to phase out after $100,000 of modified adjusted gross income (“mAGI”) and is completely out after $150,000 in mAGI.
Is income from a business considered earned?
Business income qualifies as earned if meeting IRS tests, particularly for sole workers in side hustles. Being the primary worker, with at least 100 or 500 annual hours, also designates the income as earned.
Learn With Erika
- Free 5 Day Investing Challenge
- Learn how to get started as a beginner investor and make your first $10,000
- Free 5 Day Savings Challenge
- Discover how you can save $1,000 without penny pinching or making major life sacrifices
- Join Erika Kullberg Insiders
- Ask investing questions, share successes and participate in monthly challenges and expert workshops
