Introduction
When it comes to your financial well being, you must first of all understand how you get the money, i.e the source of your income. Thus understanding income is one of the key elements towards your goal of financial soundness. There are two types of income,i.e, active and passive income. Whilst most of us view it as unnecessary to differentiate between the two, knowing the difference can open your eyes to new possibilities.
What is Active income?
Active income is basically the income that you receive after materially participating in a trade or service. Examples of active income include salaries and wages, commissions and tips, self-employment income from business activities. Deferred compensation, taxable social security and other retirement benefits, and payments from partnerships to partners for personal services can also be considered as active income.
What is passive Income?
Passive income includes regular earnings from a source other than an employer or contractor. The Internal Revenue Service (IRS) says passive income can come from two sources, i.e, rental property or a business in which one does not actively participate, such as being paid book royalties or stock dividends.
Distinguishing feature of active and passive income.
The key distinguishing feature of active and passive income is material participation. For one to be considered to have materially participated in an activity they need to have met the criteria set forth by the Department of the treasury, Internal Revenue Service (IRS).
Material participation tests.
You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities under Recharacterization of Passive Income, later.
- You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
Source: Internal Revenue Service. “Publication 925 (2022), Passive Activity and At-Risk Rules,” https://www.irs.gov/pub/irs-pdf/p925.pdf, Page 5, Accessed 17 April 2023
Active income over time.
The average income at various age groups varies significantly from country to country but generally follow the same patterns. The chart below shows the general trends of active income per age group.
In the age group 15-24, individuals would have just finished college/university and would be getting into the mainstream industry. The income levels are low at this point and gradually increase as one becomes more experienced in their field and starts assuming senior roles in their organisation. The income will most likely peak, at the age group 45-54 then thereafter begin to decline as some begin to take early retirement. Post 65 years most individuals will have reached retirement age and the income will have significantly declined.
Given the dynamics of how active income is likely to evolve over your lifetime it is of paramount importance that you maximise on the amount of active income at each stage in your lifetime.
How to maximise Active Income?
Ask for a pay rise.
Yes, ask for a pay rise – surprising as it sounds! This is the easiest way to get an increase in your active income. Employers do not always have your salary at the top of their list and may be quite happy to carry on paying you an unchanged rate for the duration of your employment. This can be an awkward conversation, but if you don’t ask, you may never get!
Therefore before asking for a pay rinse you need to do your homework on what the industry salary is for persons in a similar role and experience. As part of the negotiations is it also imperative to highlight the additional duties and responsibilities you have taken up or are willing to take up to justify the rise. Seeking a rise should always be done in the confines of the organisation’s policies.
Seek for promotion within the organisation.
Have a look to see if there are any available opportunities for promotion within your organisation. As you gain experience in your field, it is important that you seek better paying opportunities. It is important to list your achievements and ways you have developed within your current role. It is also important to reflect on any gaps or productivity problems in the workplace and show how you could help to support them and solve these problems. Improving your skill sets in preparation for promotion may be a way to show that you are serious about investing in the organisation.
Seek for opportunities outside your organisation.
According to research, frequently changing roles will result in higher remuneration. You can look at your local jobs boards to compare job roles, salaries and company benefits. In order to give yourself the best shot at landing the role your curriculum vitae should be updated to include your achievements in your current role. It is also important to conduct a thorough due diligence on your prospective employers as changing employers may be risky. You can make use of hiring managers or recruitment agents. This way you can get a better sense of the organisation and they are better placed to help you land that role.
Search for global Opportunities.
The world has become a global village, and you should not be limited to finding opportunities in your locality. Websites such as LinkedIn Job Search, Glassdoor, Indeed, ZipRecruiter, etc can help to compare job roles, salaries and company benefits globally. When considering global opportunities it is important to consult family and friends before making the decision. In seeking for global opportunities it is important to consider the immigration laws of that country, the culture, living expenses, lifestyle amongst other considerations.
Gain additional qualifications.
Always look into what training, apprenticeships, professional qualifications, Post graduate diplomas/degrees, certifications and projects you could potentially commit that will give you the right skills to make a career move. In most cases your employer will assist you in some of these initiatives. There are also free training courses on Alison andCoursera to improve your soft skills, language and other technical skills. Gaining a certificate, new experiences or training in your area of specialisation will increase career prospects.
Become an entrepreneur.
It is worth noting that being an entrepreneur is not for everyone, and the risk of failure is huge. It is also relatively easier to start your own business in some fields than others. As an example it is easier to start your own legal or architectural practice than it is to start an accounting practice and challenge the “Big 4”. During the course of your employment it is inevitable that you will build experience, knowledge of your field and your own network of mentors, partners, employees and investors. Leveraging on this you can build up a successful business of your own, which can significantly increase your active income.
Conclusion
Active income is the most common income that is available to the majority of us, and it is important to make hay whilst the sun shines. At every opportunity in your lifetime always strive to maximise your active income.
