When you mention the word “income” to most people, the first image that often springs to mind is a paycheque. You go to a job and earn some money. At the end of the year, your employer will send you a P60. You'll put that on your tax return, and that's the income you made for the year. However, as with most financial topics, income is far more nuanced than that. There's active vs passive income.
Here's what you need to know about these two types of income, including which is the best (and how you can build both!).
Active vs Passive Income: What's the Difference?
Active income refers to any money that you have to work to get. When you go to work for a salary or hourly wage, you're earning active income. This term also refers to side hustles that you may have, like freelancing, running a YouTube channel, photography, or tutoring.
On the other hand, passive income refers to money you don't have to work to earn. When you put money in a bank account, and it accrues interest, that's passive income. There was no labour you had to put in to make that interest. Another way to look at it is that passive income is money that you earn on previous labour. You had to make the initial money to put in the bank account, but now it's in there, and it continues to earn even more money.
Therefore, active vs passive income boils down to whether you need to work for the payments.
Which Type of Income Is the Best?
If you read online, practically every “get rich quick” site extolls passive income benefits. If you could only build a business that runs on autopilot or invest enough money, you'll make wads of cash and can retire on some exotic island. Many of these sites are scams because making that level of passive income requires a significant amount of hard work and dedication.
However, while the benefits of passive income are substantial, the reality is that it's often best to have income from both types.
Why Is Passive Income Not Always Superior?
Passive income is lovely, and there's something deeply gratifying about earning money without working, but it tends to fall into one of two categories:
- substantial, but not necessarily reliable
- reliable, but not necessarily very much
Consider an investment in the stock market. As you know, stocks can go up or down, and your portfolio can fluctuate rapidly with the market. If you're looking to pay off your mortgage with trading, you'll need a substantial portfolio and a lot of luck to avoid a recession hindering your ability to pay. Stocks have the potential for significant income, but they're not necessarily as reliable as other investment vehicles.
However, now consider a bank account. In today's environment, you'll be lucky to earn even 1%. This rate means that you're only looking at a £10,000 return even if you had £1 million in the bank.
Therefore, passive income, alone, is often not enough to live on – at least for most people.
The Importance of Multiple Income Streams
In investing, advisers often talk about diversification and the importance of diversifying your portfolio. That advice is excellent, but it also applies to your income streams.
Consider the following scenario. Let's say you have a job, a side hustle, a bank account, and some stocks. Your job probably earns the most. But, if you lose your job, you have your interest, capital gains, and side hustle to keep your finances afloat. Similarly, if the stock market goes down or your side hustle runs into troubles, you have each of the other streams to help you continue to improve your finances.
By diversifying your income streams, it's not necessarily active vs passive income anymore – it's about having multiple sources so that you aren't dependent on one particular job, one bank account, or one set of investments.
Active vs Passive Income: Generating Money from Each Type
Fortunately, it's not too challenging to have these multiple income streams. All you need is a computer, the internet, and a little time to research and apply for some accounts.
Active Income Ideas
Besides your day job, we compiled a list of the top 10 side hustles you need to know if you want to earn extra money. Some of these hustles can grow into full-time jobs in their own right. The top YouTube star of 2020 is a nine-year-old that earned $29.5 million last year (about £21.6 million).
Passive Income Ideas
There's a misconception that you need a lot of money to start investing and earning passive income. That's not true at all. You can begin investing with next-to-nothing because you can take advantage of the fact that UK brokerage apps will give you free stocks for opening an account. Just by opening an account, you can start your journey to earning passive income.
One of the best investment platforms, Webull, offers three free stocks when you sign up for an account with them. M1 Finance is an excellent platform for those looking to earn passive income from buy-and-hold stocks. If you're interested, you can read our M1 Finance vs Webull in-depth comparison.
Passive index funds are another option worth taking a look at, Luke from theprogressionplaybook.com has a post on the best platforms.
Finally, rental properties are another popular source of passive income. If you have the funds, you may wish to consider getting a second property that you can rent out. Not only will you earn rental income, but you can also take advantage of property appreciation – another form of a passive income!
It's Typically Best To Have Both Types of Income
Having multiple income streams is almost always better. In many respects, active income and passive income are symbiotic. The more active income you have, the more you can invest passively. The more you have invested passively, the more freedom you have to pursue your dreams and goals, which typically result in the best success of making active income!
With multiple income streams, you'll find it much easier to meet your financial objectives. Not only will you earn more money, but a problem with one income stream (e.g. extended job loss) will not necessarily throw all your other financial aspirations asunder.
If you want to add new income streams, consider some of the tips and tricks provided in this post. You'll often find that it's easier to do than you think!