Why You Need Both Passive and Active Income

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Why You Need Both Passive and Active Income

Written by Bryan Daly
Fact-checked by Caitlin Wood

Why You Need Both Passive and Active Income

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Income Investing Saving

As you get older and take on more expenses, eventually you may need to start earning a higher income. Not to mention, making a steady income is one of the best ways to get approved for important financial products and services, like an affordable mortgage or car loan. Thankfully, there’s more than one way to rake in a respectable income. 

Keep reading to learn the differences between passive and active income, as well as the reasons you should be making both at the same time.

What is Passive Income?

Passive income refers to any money you can generate with little or no effort involved. So, unlike your 9 to 5 job, where you have to put in a specific amount of work to make an income, you can invest time and/or money, then wait for the potential returns. 

Essentially, while passive income may not be as consistent or profitable as your regular salary or wage, it’s extra money you can make from the comfort of your own home.       

What is Active Income?

Active income is almost the opposite of passive income, meaning you’ll generally have to work harder and put in more hours to earn it like you would at your day job. That said, you can make an active income whenever you trade your time for payment. More often than not, people put forth the effort in their earlier years, then gradually try to make passive income so that they can live easier later in life, then hopefully retire comfortably.           

Types of Passive and Active Income

In Canada, you can earn many types of passive and active income, each with its own set of benefits and drawbacks. Here are some of the most common examples: 

Passive Income

  • Investments or Savings Accounts – When you make a return on your Tax-Free Savings Account (TFSA), Registered Retirement Savings Plan (RRSP) or other investment, it counts as passive income. While some investments are risky, the more money you add to your account, the more passive income you can collect.
  • Peer-to-Peer Lending – This service allows you to anonymously invest money in borrowers via an online platform, often in the form of loans or other financing products. So, when a borrower pays back their debt, you can collect a regular passive income from whatever interest the account generates. 
  • Rental Properties – Another expensive but simple way to earn income passively is to buy property and rent it out. While long term rentals can sometimes yield better results than short term rentals, you’ll have to deal with the all upkeep, financing and tax bills of what could be multiple properties.
  • Dividends – Dividend stocks regularly disburse a portion of a company’s revenue to various investors. A business gradually increasing its payouts over time normally yields the best returns. So, if you invest in dividend stocks, you can make passive income and diversify your stock portfolio at the same time.   

Active Income

  • Salary or Hourly Wage – Of course, most people’s primary source of active income is their job. Whether you work for a company, small business or your work for yourself, you must put in a specific amount of time and effort in order to generate enough income to cover the cost of living.
  • Commission – In some industries, you may be able to earn extra money from commission fees by conducting various customer transactions. For instance, if you work in sales, you can make a percentage of how much you sell. Your employer may also pay you in cash, based on your overall sales productivity. 
  • Tips – Similar to commission fees, tips are extra income that you can make after conducting some kind of sale or service. However, how much you earn is up to the customer, as tipping isn’t usually obligatory. While a 15% tip is a standard request in many industries, even hard workers might not earn what they deserve.    
  • Side Hustles – Earning money with side hustles, like private tutoring, freelance work or other odd jobs outside of your regular salary/wage can also qualify as active income. Even if you don’t earn a steady stream of money from the side hustle, every dollar counts, especially if you market your skills well.

Pros and Cons of Passive and Active Income

There are many benefits and drawbacks to all forms of passive and active income, including but not limited to:

Pros of Passive Income

  • Less Effort Needed – You usually don’t have to work hard to earn a passive income and you can save a bit of stress on your body and mind. You choose the payment method, as well as how much time and money you want to invest.
  • The More Time & Money You Invest, the More You Can Earn – If you’re patient and prepared to handle any problems that come your way, the eventual rewards can be worthwhile, even if you have to wait years for your investment to pay off. 
  • Live More Comfortably – As mentioned, many people like making passive income because it can slowly reduce their workload. Not only can it help you retire earlier, but you can also use it to free up more time and live the way you want.
  • Diversity & Growth – Some forms of passive income can have a compounding effect, allowing you to earn more and more money over time (maybe even an unlimited amount). Plus, diversifying your financial profile is never a bad thing.   

Cons of Passive Income

  • Commitment is Necessary – You may have to invest a lot of time and money before you see a decent return. Even a simple stock portfolio can require plenty of upkeep, only for the payoff to be underwhelming years later. 
  • Risk is Possible – Certain kinds of passive income, such as investments, can definitely be risky. Not only could you lose money when the market takes a dip, but it can also take years before you see a truly worthwhile return.
  • Outsourcing May Not Be an Option – Most of the time, you’ll have to monitor and disburse funds toward your own sources of passive income. After all, investment professionals and financial advisors can only do so much.     

Pros of Active Income

  • More Frequent Payments – If your employment is salary or wage-based, you’ll generally see a faster reward for your efforts, since most regular jobs are paid out on a bi-weekly basis (while some contract work can be less frequent). 
  • A Steady Living – If you hold down a good job with a reputable business, you should be able to earn a stable income for an extended period. Even contracting and freelancing can yield a decent active income if you find regular work. 
  • Potential Opportunities – Some jobs are competitive and allow you to move up in the business, which can help you secure a higher income and better employee benefits, such as dental insurance and other types of coverage. 
  • Less Financial Stress – If you use your active income responsibly, you should be able to deal with your everyday expenses with little to no stress. Plus, you can save for any large future costs, such as mortgage payments or a family vacation.

Cons of Active Income

  • More Time & Work Required – Working full-time for years on end can be very tough on your body and leave you with less time for personal matters, especially if you’re working in an entry-level position or starting your own business. 
  • Not All Jobs Are Great – Unfortunately, it can be tricky to find an employer that treats you well and pays you what you’re worth. Running your own company can also be extremely risky, expensive, and time-consuming until the business takes off. 
  • The Opportunities Might Be Limited – Another unfortunate thing about some everyday jobs is that they may not offer up the advantages you were hoping for. All salaries have a maximum cap and employee benefits may not be guaranteed.

Why Do You Need Both Passive and Active Income?

In Canada, the average cost of living can be substantial and once you’re past a certain age, it can be tough to get by without having at least one reliable source of income. In fact, the more types of income you can earn, the easier it will theoretically be to get your biggest expenses out of the way, save up money and take time for yourself.

Although you can accomplish all this if you manage to find a decent job, the simple truth is that you may end up living paycheck-to-paycheck for a long time. That’s why it’s a good idea to start making passive income on the side. Even a basic RRSP, TFSA or stock portfolio can accumulate a lot of interest over time and help you buy a home, finance the vehicle you’ve been eyeing or reduce your workload later in life. 

Passive & Active Income – FAQs

Is passive income taxable in Canada?

Yes, just like active income, most types of passive income are subject to taxation in Canada. Different tax rates and brackets exist for different sources of passive income. 

For instance, by making more passive income, you may fit into a higher tax bracket and have to pay more during tax season. The same rule applies if you’re married and filing joint passive income taxes (the higher your household income, the more you’re taxed).

How much money can you make with a passive income?

The amount of passive income you actually make depends on which method(s) you’re using to earn it, as well as how much time and money you’re willing to invest. Remember, while passive income can be easier to earn than active income, it may require some skill, patience and commitment before you see any favourable results.

If you’re financially prepared and willing to accept some risk, you can invest more and potentially receive a bigger payout several months or years later. However, if you want to take as little risk as possible, there are still plenty of safer investments and financial accounts that you can use to collect a decent amount of passive income.

Are capital gains considered passive or active income?

If you make a profit by selling stocks or real estate properties (capital assets), it qualifies as a capital gain, which is considered a form of passive income. The same principle applies to your personal assets, like your vehicle or home. The amount you eventually pay in taxes depends on how long these kinds of investments are held for. 

For example, if you make any capital gains from a short-term investment (one year or less), they may be taxed at a similar rate as your regular income. If you invest long-term (for more than one year), your gains might be subject to a lower tax rate. 

Interested in Earning Some Passive and Active Income?

If that’s your goal, a bit of hard work, financial knowledge and commitment can go a long way. Don’t forget, it’s all about the big picture. If making a passive income on top of your regular wage or salary helps you free up more time and money for future use, then the investment has definitely been worth it.

Investing Glossary

Terms
Annual Report

A yearly report provided by a company to its shareholders that discusses the business activities and finances from the past year.

Annuity

An annuity is a financial product that pays out a guaranteed income. It is used mainly by those who are putting a retirement plan together. When an investment is made in an annuity, it then makes regular payments at a date or dates in the future to create an income stream for retirement.

Asset Allocation

A type of investment strategy that aims to balance risk and rewards by adjusting the portion of money invested in different types of assets in an investment portfolio. The specific investment strategy depends on the risk tolerance, time frame and goals of the investor.

Bond Fund

A mutual fund that invests in bonds or similar debt securities, also known as a debt fund. 

Bond Maturity

The term to describe time passing throughout a bond’s term. At the bond’s maturity date, the end of a bond’s term, the principal and interest will become due to the investor. 

Bonds

A type of debt security or financial instrument that represents a loan made between an investor and a borrower. The borrower is often a corporate or government body. Bonds are lower risk and yield less return than other types of investments. 

Common Stock

A type of equity ownership in a corporation. Holders of common stock vote on corporate policies and elect the board of directors.

Diversification

Investors are typically encouraged to diversify their loan portfolios in order to hedge against risk and garner the highest returns since different assets react differently to the same economic events. Diversification refers to a portfolio that consists of various assets that are not correlated with one another.

Dividend

An amount of money that is paid on a regular basis by a company to their shareholders. The amount paid comes out of the company’s profits.

Dividend Yield

The ratio of a company’s dividend per share to the price per share. The dividend yield communicates how much dividend income you received in relation to the price of the stock. The ratio is most commonly expressed as a percentage.

Enterprise Value

A measure of a company’s total value typically used as an alternative to equity market capitalization. The calculation considers market capitalization, short term debt, long term debt, and cash on hand.

Equity Fund

A mutual fund that invests primarily in stocks, also known as a stock fund.

ETF

ETF stands for exchange-traded funds. To put it simply, an ETF is like a mutual fund where it is comprised of securities like stocks and bonds and, like stocks, can be traded on the stock exchange. You are able to buy and sell shares of the ETF, like a stock, without having to buy each bond, stock and other securities separately. You own a part by buying the ETF which is comprised of these securities.

Guaranteed Investment Certificate (GIC)

A GIC is considered a low-risk investment vehicle because it is guaranteed. It works similar to a savings account because the money deposited in it earns interest.

Index Funds

A type of mutual fund that is built to match or track a financial market index, such as S&P 500. Index funds are low risk which makes them safe investments, but there is little opportunity for big earnings.

Investment

When an individual or entity contributes money towards something with the intention of turning a profit or gaining a material outcome, it is considered an investment. All of the money invested would be considered an individual or entity’s investments.

Investment Advisor

An individual or group that manages money or makes financial suggestions on behalf of another individual or group in exchange for a fee. 

Market Cap

The market value of a public company’s outstanding shares. The market cap is calculated by multiplying the share price by the outstanding number of shares.

MER

MER stands for the management expense ratio. The management expense ratio includes management fees, operating expenses, and taxes associated with a fund.

Mutual Funds

A mutual fund is a portfolio of different securities (stocks, bonds, short-term debts) that many people can invest in. Rather than diversifying your investments by buying different securities yourself, you can invest in a mutual fund. Depending on how much you invest, you will own a share of the mutual fund. This allows investors to have their hands in different stocks with one transaction.

Number of Holdings

The sum of all holdings types in a fund, investment or portfolio. For example, if you have a portfolio with common stock, bonds and preferred shares, the number of holdings would be three.

Par Value

Par Value – Par value refers to the value of a stock as stated on the stock certificate or the corporation’s articles of incorporation. The par value per share is typically of very little or no value.

Portfolio Management

The professional science and art of executing investment decisions and performing investment activities on behalf of an individual or institution.

Portfolio Rebalancing

Portfolio rebalancing is the act of consistently balancing your investments according to your needs by buying and selling assets.

Preferred Stock

A type of equity ownership in a corporation. Holders of preferred stock have a higher priority when it comes to dividends or asset distribution when compared to common stockholders.

Premium Bond

A premium bond is one that costs more than its face value. Bonds may trade at higher values as a result of a higher interest rate compared to current market rates.

Price to Earnings Ratio

The ratio of a company’s share price to earnings per share. This ratio is used to determine if a business is overvalued or undervalued.

Price-to-Book (P/B) Ratio

The P/B ratio refers to a company’s stock price divided by its book value per share (total assets less liabilities). Low P/B ratios may be a sign of an undervalued stock.

Reinvest Dividends

The process of investing dividend cash payments into the company or fund that provided that dividend.

Risk Tolerance

Risk levels vary with different investments. While some investments come with low risks, others are riskier in nature. Risk tolerance refers to the amount of risk that an investor is willing or able to undergo when investing in a particular investment vehicle.

Share Price

The price of a sole share in a company. A share price is not fixed and fluctuates depending on market conditions.

Shareholder Value

The value brought to equity owners of a corporation as a result of management’s actions to increase sales, free up cash flow, boost earnings, pay out dividends, and earn capital gains for shareholders.

Stockbroker

A professional who purchases and sells securities on a stock exchange for their clients.

Stocks

A type of debt security or financial instrument that represents ownership share in a company. Issuing stock is a way for companies to raise money and investors to turn a profit. Stocks carry more risk, but have the possibility for greater returns. Once you own a share of the company you can gain money through dividends paid out by the company or by selling the stock for a higher price than when purchased.

Tax-loss Harvesting

The practice of selling an asset or security that has incurred a loss with the intention of offsetting taxes on capital gains and income. Using the proceeds of the asset or security sale, a similar asset or security is purchased to maintain optimal returns and investments.

Volatility

The statistical level of variation of a trading price over time. Often, volatility is measured using the standard deviation of logarithmic returns. When volatility is high, the risk of investment is also high.

Yield to Maturity (YTM)

Yield to maturity refers to the total anticipated return on a bond if it is retained until maturity. If an investor holds onto a bond until it matures, the YTM is the rate of return of an investment if all scheduled payments are made and reinvested at the same rate.

                                                                                                                   


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