Earned vs. Passive vs. Investment Income: Key Differences

Why do some people grow their wealth comparatively effortlessly while others seem to struggle to make ends meet?

The answer greatly depends on how they earn, manage, and diversify their income. Understanding the difference between earned, passive, and investment income while distributing resources wisely is how you unlock new growth opportunities. 

But how do you reduce dependency on a single source and pave your way for long-term financial freedom? 

Different Types of Income Explained

Income is the lifeblood of our everyday financial journey, with all its ups and downs. It’s what puts food on the table, pays for our bills, and allows us to indulge in luxuries. But not all incomes are equal.

Earned Income: The Workhorse of Your Finances

Earned income refers to the money you earn by working for someone or managing your own business venture. Such income is directly tied to the time, effort, and expertise we put into our jobs or businesses. Earned income can also be active if you are compensated for active work. That said, a key characteristic of earned income is its dependency on your continuous participation, when you stop working, the income ceases.

While earned income is often the foundation of financial stability, relying solely on it can limit long-term wealth-building potential, as it leaves little room for generating income independent of daily effort. Diversifying beyond earned income is crucial to creating a more balanced financial strategy.

Most Common Types of Earned Income

• Salaries and wages, including regular paychecks from an employer in exchange for work. This is the most stable and predictable form of income that comes from full-time or part-time jobs and is paid in return for office jobs, manual labor, and similar activities.
• Freelance earnings arise from project- or contract-based work that is charged at an hourly or project rate. Unlike fixed-earned income types, freelance workers have more freedom to negotiate their rates and work schedules. This type of income offers more freedom, but it’s not as stable as salaried compensation.
• Commission-based roles, like real estate agents, salespeople, recruiters, etc can receive rather appealing income through a percentage coming from the closed bills. However, this type can also be less predictable, especially when a product or service is not in high demand.
• Self-employed income from consulting or owning a business offers more adjustments and customization.

Earned income offers stability and is usually the first source of revenue people rely on.

What Is Earned Income Tax Credit?

EITC or Earned Income Tax Credit helps low- to moderate-income workers receive refundable credit.  This implies that contrary to other tax credits, you can receive an EITC refund even if it exceeds your income tax liability.

To qualify for the Earned Income Tax Credit, one should meet certain income thresholds depending on their financial status and the number of qualifying dependents at that moment.

Benefits of Earned Income

Earned income provides the financial foundation for most individuals and families. It’s the money you actively work for, offering consistent and reliable paychecks that form the backbone of everyday expenses and budgeting. While it may not always lead to exponential wealth growth, earned income is critical for meeting immediate financial needs and building a safety net.

Provides financial security: People with a steady salary or wage are more confident in the money they will get to cover housing, food, healthcare, and other expenses. Such a sense of stability makes it easier to plan and manage finances.

Provides access to corporate benefits: Your salary or wage comes with a number of benefits your company is ready to cover. Additional perks like health insurance, retirement savings plans, and occasional bonuses can significantly impact your financial health and help you reach long-term goals.

Passive Income: Money That Works for You

Many often view passive income as a financial holy grail as it requires relatively little to no daily commitment once established. This type of income refers to money earned from assets you own that continue generating cash flow without direct involvement on your behalf.

Although this may seem beneficial and desirable, having a well-developed plan before starting an initiative can save you from possible losses. You’ll still be required to invest money, time, and effort into the desired income source and wait for the right moment to reap its rewards.

Examples of Passive Income

• Rental property income is among the highest-paying side incomes, but it also requires significant initial investments. First, you’ll need to purchase and then maintain the property, and only then can you expect to earn a steady monthly income.
• Royalties from creative works like books, music, or patents generate income for creators. However, as an author, you also need a significant upfront investment to create and promote your work.
• Selling pre-made digital products, like ebooks, courses, graphic art, etc., can be one of the easiest and most passive sources of income. You’ll need to invest time and effort into creating the product, but once it’s out there for purchase, you can earn money without actively engaging in the process.

However, if you want any of the abovementioned or other passive income sources to generate significant amounts of money, you’ll need an effective marketing strategy and a solid understanding of the market in which you’re operating. Combine this with ongoing involvement, and a passive income can quickly turn into a steady income flow.

Benefits of Passive Income

For those willing to achieve financial freedom and reduce their daily commitment, passive income is the go-to solution. It allows us to allocate more time to other aspects of our liveslife like personal growth, work-life balance, and even exploring new business ventures. Although this type of income requires initial investment and continuous dedication, its benefits are worth it.

Diversifies income streams: Passive income is a way to make extra money and add an additional layer of financial security supplementing earned income.  It creates additional income sources to protect you from job loss or other unexpected circumstances that can quickly drain your savings.

Builds wealth over time: Passive income often has compounding effects, meaning if you have more than a single income source, the money can accumulate and grow even when you’re not actively working. This type of income is a long-term game that can eventually lead to financial independence and early retirement.

Investment Income: Earning Money Through Assets

Investment income is the profit you get from stock sales, mutual funds, cryptocurrency, or other forms of investment. Its hands-on approach differs from passive income, requiring more active involvement in monitoring, following market trends, knowing stock market secrets, and making strategic decisions for higher income.

Timing and initial investment capital play a crucial role in maximizing returns. For instance, if someone invests $100 into a stock that appreciates 10%, they’ll earn $110. However, if the market takes a turn and falls by 50%, their investment will now be worth $55. No one can guarantee the final outcome from investments. It all depends on the market conditions and economic trends that decide the worth of your assets.

Examples of Investment Income

• Fixed-income investments like bonds refer to regular interest payments and a comparatively stable form of investment. An example of such investment is a Certificate of Deposit (CD) offered by banks.
• Investors can also receive income from annuities, the so-called financial products designed to provide a steady income, especially during retirement. You invest a lump sum with an insurance company and start receiving regular payments for a set number of years or the rest of your life.
• Investing in mutual funds or exchange-traded funds (ETFs) generates income through dividends or interest earned by the underlying securities in the fund.

Benefits of Investment Income

Investing money into something you believe will grow and bring you more income is creating a venture where money works for you.

• Enables compounding growth: Investment income, particularly from reinvested dividends or interest, benefits from compounding. This growth mechanism amplifies your returns and significantly increases wealth over the long term.
• Offers tax advantages: Certain investment mechanisms are taxed at comparatively lower rates than earned income. When planned right, this type of income can result in long-term capital gains.

FAQ

Learning how to make extra money is one thing, earning it is another. Check some of the commonly asked questions to find the best alternative source of income for you.

How Is Earned Income Tax Credit Calculated?

You can calculate your Earned Income Tax Credit (EITC) while considering several factors: 

• your current earned income
• the adjusted gross income (AGI)
• filing status
• the number of qualifying dependents you support. 

This is a progressive tax credit, meaning it can grow with your earnings up to a certain threshold and will gradually phase out as your income continues to grow. 

For example, the credit begins to phase in as your income rises, reaching a maximum amount at an established income range. This peak credit amount varies depending on the number of qualifying children. Taxpayers with no dependents have a relatively smaller maximum credit than those with three or more dependents.

Which Investment Type Is a Fixed Income Investment, Meaning You Get Paid on a Regular Schedule?

Bonds, certificates of deposit (CDs), and certain annuities fall under the category of a fixed-income investment. These are popular choices for people who look for stability and reliability in their investments. 

Government bonds like the U.S. Treasury bonds pay semiannually bonds and are secured by the government. Certificates of deposit offer investors fixed interest rates over predetermined periods in exchange for locking their funds with a financial institution.

What Disqualifies You From Earned Income Credit?

Some of the most common disqualifying factors include the filing status, residency, income thresholds, and the nature of your income. The adjusted gross income (AGI) and the earned income should fall under the IRS’s annual limits. Another thing is considering the filing status. For instance, the “married filing separately” status won’t claim you the credit. Non-residents who fail to meet the substantial presence test will also be disqualified.

What Is the Best Reason Why Someone Would Want to Claim the Earned Income Tax Credit on Their Taxes?

It’s a great relief and financial support for families and individuals who must work hard to make ends meet. Unlike other tax credits, the EITC is refundable. This means that once the credit score exceeds the total tax liability, a person can receive the remaining amount in a refund. 

Besides immediate financial relief, EITC has rewards and incentive work.