If you read any financial literature, chances are you’ve come across the terms active income, passive income, and portfolio income. You might wonder what each of these terms means and which one is the best type of income, especially when it seems that there almost as many recommendations as there are authors. Here’s the quick rundown:
Active Income: the income you earn from work you perform. It can either be an hourly wage or an annual salary, depending on the exact position. Generally speaking, if people ask you what you do for a living, you’ll respond with your source of active income. Also known as ‘earned income’.
Pros: You can make more money initially via active income than you could with passive income (that is, the income from the first month at a new job will be higher than your first month’s profit from most passive sources). Also, you can usually raise your active income simply by working longer, which will result in more paid hours or possibly a raise.
Cons: You need to keep working to keep making money; if you quit your job or get fired, your income stream will dry up. (Also, it’s been argued that the tax system favors other sources of income, at least here in America; but that depends a lot on your specific situation.)
Passive Income: the money that’s earned which doesn’t require your material involvement. Common examples are rental income on properties, royalties from books, and blogs (like the one you’re reading now). Once the initial work to create them has been completed, the amount of money they earn is independent of the time devoted to them.
Pros: Your income does not depend on the hours of work performed. That is, once the book or website has been created or the rental property purchased, the income can grow independently of the time spent by the owner. As a result, it’s possible to earn money in your sleep with such income sources.
Cons: Your income does not depend on the hours of work performed. The nature of passive income is a double-bladed sword. While it’s true that you can conceivably earn much more money creating passive income sources than you could with active income, you can also spend time creating a website or buying rental properties that end up returning nothing (or even costing you money).
Portfolio Income: Sometimes considered a sub-section of passive income, portfolio income comes from monetary investments in things like stocks, bonds, and mutual funds. Usually, portfolio income refers more specifically to money generated in the form of dividends, rather than increasing prices (capital gains). Portfolio income involves using your money to make more money, by putting it into vehicles for financial growth.
Pros: Like passive income, portfolio income grows without requiring your involvement. Once you’ve put your money into a particular investment, the money can grow without you needing to do anything else at all. (Although, watching your investment in case things change is always a good idea.)
Cons: To generate portfolio income, you need money in order to start investing; you’ll need another source of income to create your portfolio. Also, as the recent events have shown, there is a lot of volatility in the financial markets, and you have to have back up plans in case your portfolio does not perform as well as expected.
Which type of income is best? The answer to the question is, they all have their own uses as you create a stable financial future. Active income will help you generate seed money that can be put into your portfolio. Your portfolio will grow and build up, enabling you to get more portfolio income out of it. And passive income sources can be cultivated, providing you with supplemental money to put towards your financial goals. Combine the three, and you’ve got a full and bountiful garden, ideal for creating a solid financial future.
Menandro Tomas February 18, 2010 at 6:20 pm
I would ultimately choose the third.
But when we are just starting out especially as an employee, it is a good strategy to use it until we can go to the next level which is passive income.
Then when passive income is accomplished, we know the next goal.
Roger February 19, 2010 at 2:28 pm
@Menandro Tomas: Indeed, I would, as well. The whole goal of this article was to point out the interconnectedness of the tree types of income, and how you can use each type of income in its own way to build your financial future.