Blog | Entrepreneurship

Passive Income vs Earned Income: Not Created Equal

Why you should turn ordinary income into passive income, and how to do it

Summary

• Knowing the difference between passive income vs earned income is crucial for becoming rich

• Passive income comes from cash flowing assets, not your 9-5

• Turn your earned income into passive income by adopting these simple strategies

---

Think about it: The perfect world, where you could turn your business into an investment where you don’t have to go to work. Sounds too good to be true…but is it?

Granted, the process of turning a business into a passive investment where you don’t have to go to work takes some serious effort, but the rewards can be huge .

The good news is that even if you’re not to the point where your business runs without you working, it’s easy to turn the income from your business into passive income for tax purposes. Here is why you would want to do this and a few simple steps for getting it done.

Different Types of Income

Remember that the right side of the CASHFLOW® Quadrant includes both business owners and investors. But there’s one catch; you can’t be a typical investor if you’re going to enjoy the tax benefits of investing. You have to become an active investor. That means you have to be an investor who actively invests for passive income, not earned income.

Three types of income

In every country, there are different types of income, and they all have different associated tax rates, costs, and benefits.

Earned income

If you are an employee, a self-employed individual or a partner, you make your money through earned income. Earned income is taxed at the highest rate possible.

Portfolio income

Where earned income is acquired by exchanging time for money, portfolio income is made through capital gains. This type of income is always better than ordinary income. The reason Warren Buffet pays only 17 percent on his income is that most of his income is investment income.

Passive Income

Very simply, passive income is income that comes from dividends, rents, and business. It’s taxed at a much lower rate than earned income, which comes from appreciation and capital gains, or from your paycheck. In order to become a super investor, you must find good, cash-flowing investments that produce passive income.

When you have passive income, you can offset your income with losses from your real estate investments, for example. Real estate gets such high depreciation deductions that you can have losses for your tax return even though you have positive cash flow from your real estate. The challenge is that real estate rental losses in the United States are considered to be passive losses and can only offset passive income.

The point is this: not all income is created equal. Passive income, the kind of income generated on the right side of the quadrant is much better than earned income, the kind earned on the left side of the quadrant. Passive income is taxed less, and it's also a result of cash-flowing assets, not selling your time as an employee.

Convert ordinary income into passive income

Many people start their lives earning money the same way: by doing a job and getting paid for it. The key to growing your wealth, however, is by converting your ordinary income into passive income to lower your tax rate.

Case study

Say the owner of a restaurant earns $200,00 after his normal expenses through his restaurant this year. If he took all of that money out of the business, it would be taxed at regular rates. He doesn’t want to do that. So instead, let’s say he puts $80,000 back into the business in the form of additional supplies and equipment that will make even more income for him in the future and then puts another $20,000 into marketing.

All of the money Pierre puts back into his business is deductible against his $200,000 of income. That would leave him with $100,000. Now let’s say that he has a home office and that his van is used primarily for business; that when he spent money on a vacation, he took his wife and children, who are all owners of the business with him and that they spent more than half of each weekday on business; and that whenever Pierre and his wife went to dinner during the year, they had a business discussion.

In total, Pierre could easily have another $30,000 in expenses that he could use to offset his income. That leaves only $70,000 to be taxed. And after his deductions for his mortgage, taxes, and charitable donations, he’s down to $40,000 of taxable income. And after his personal exemptions, he’s down to less than $20,000. If he’s in the United States, this $20,000 will be taxed at a 10 percent rate. So he only has to pay $2,000 in taxes on $200,000 of income. If he were an employee on the left side of the CASHFLOW Quadrant making a salary of $200,000, even after he took his deductions for mortgage interest, taxes, charitable donations, and personal exemptions, he would’ve paid a tax rate of about 20 percent on the remaining $150,000—that’s $30,000.

Understanding how the different types of income are taxed will help you so that you can have a real discussion with your accountant and so that you can keep a lookout for the good, better, and best types of income (i.e., those with the lowest taxes). Even if you aren’t good at math or at keeping track of things like this, you can still have all of the advantages of low-taxed income just by having the right people on your team and finding a great accountant to assist you.

To learn more about lowering your taxes, get Rich Dad Tax Advisor, Tom Wheelwright’s book, Tax-Free Wealth: How to Build Massive Wealth by Permanently Lowering Your Taxes