The 6 Categories of Passive Income, Explained

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Passive income refers to money that flows to you without active effort. It usually requires an upfront investment of time, money, or both to establish, but not always.
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Who doesn’t want to make money while they sleep?

Passive income refers to income that gets generated with little to no effort on your end, and it’s one of the best ways to build wealth and financial independence over time.

Of course, making money this way is also easier said than done. “Passive income isn’t something where you sit on your chair and do nothing, and then money falls off the sky,” says Katya Varbanova, a viral content creator, and social media marketing strategist. “Passive income is when you put in a strong effort initially — you put systems and procedures in place — and, over time, it continues to make you money with very little maintenance.”

One of Varbanova’s passive income streams is digital template packs for content creators, which took time and money upfront to design, but now sell on autopilot. “If I took a month off for vacation, I’d still make money.”

But what is passive income, really? Financial experts divide passive income ideas into six different categories. Here’s what to know about each passive income strategy — and how you can start implementing any or all of these passive income ideas today for yourself.

The 6 Types of Passive Income:

  1. Profit Income
  2. Interest Income
  3. Dividend Income
  4. Rental Income
  5. Capital Gains Income
  6. Royalty Income

Income Stream No. 1: Profit Income

Profit income is when you sell something for more than it costs you to purchase or create. The difference in revenue and production cost is profit income. Some popular examples include retail arbitrage, e-commerce, selling physical goods in a store, creating digital information products, affiliate marketing, and thrifting.

Related: How to Make Money on Amazon

For example, you could have an e-commerce side hustle, where you buy items from a wholesale retailer, then charge customers a markup on Amazon to turn a profit. Or perhaps you take the time to create an online course, then sell it for more than the effort it took to develop. The profit you’d make from these or other scenarios is considered profit income, a form of passive income.

“Active income is great, but it relies on your effort every day,” says Carlos Villanueva, an entrepreneur who owns a remote solar sales agency, but also makes passive income on the side through self-study courses. “You can package your process into a course and make passive income after it’s set up. You could still make money through that course passively when you’re sick or not working.” Villanueva says that creating an online course as an income stream within his company has been great for business, and has led to more time freedom.” 

Related: How to Make Money on Etsy

Income Stream No. 2: Interest Income

Interest income refers to the money you make from compounding interest on the money you have saved, invested, or loaned out.

Some examples of interest income include money in high-yield savings accounts, money market accounts, government bonds, or loaning money to others and charging interest on the loan. If you have some spare cash, you could invest that money into a high yield savings account or other interest-earning account and create a form of passive income.

In interest income, you’re making your money work for you with little or no effort.

Related: What Is Financial Independence, Retire Early (FIRE)? A Beginner’s Guide 

Income Stream No. 3: Dividend Income

Dividend income is when you invest money in shares of stock of a company that pays dividends. Certain publicly-traded companies provide dividends for their shareholders as a way to start earning passive income, but not all do. 

Some examples of well-known companies that provide regular dividends for their shareholders in the form of dividend stocks include Apple (AAPL), Microsoft (MSFT), Exxon Mobil (XOM), Wells Fargo (WFC), and Verizon (VZ).

Income Stream No. 4: Rental Income

Rental income traditionally refers to buying property, then renting it out. Real estate investing is one of the oldest and most traditional ways to earn passive income, but it requires a substantial upfront monetary investment. Some examples include buying single-family homes, apartment complexes, or commercial buildings, or putting money into real estate investment trusts (REITs), which invest in rental properties on your behalf.

“Passive income allows me to have more control of my time,” says Dawrance Constant, a partner at Arch Capital Ventures, a real estate private equity fund. “Because my rental estate investment income is passive, I’m not having to spend all of my time working to make a living.”

To get started in investment real estate, you buy a rental property with cash or a mortgage, then rent it out. Both require an upfront investment to clear the down payment. If you don’t want to deal with managing properties, you can take some of the money coming in and hire a management company. The rental property then produces partially or fully passive income each month. “Real estate has tax benefits, and allows people to get returns even if they don’t want to manage the property,” adds Constant. 

Your property doesn’t have to be real estate, either

The sublet economy is becoming increasingly popular. Many Americans are renting other assets, such as cars, boats, and even vending machines in order to generate passive income from their existing non-residential property.

Income Stream No. 5: Capital Gains Income

If you purchased an asset, then sold it later at a profit, the profit you make when you sell is called capital gains, which are another form of passive income.

Capital gains differ from profit income in that you purchased the asset, rather than creating or developing it yourself. Capital gains are also subject to a separate type of tax from the Internal Revenue Service, a capital gains tax, which should be taken into consideration when selling.

Some examples of capital gains income include buying real estate or stocks at one price, then selling when the value is higher than when you initially purchased to gain passive income. The value could be much higher sometimes, leading to a significant capital gain. Capital gains are taxed differently than income, so it’s important to consult with a financial advisor or professional before selling any major assets.

Remember that capital gains tax only applies when the gain is realized.

Income Stream No. 6: Royalty Income

Royalty income is one of the best examples of passive income. You put in work upfront and can have an income stream that pays you future income for the rest of your life, money that you can invest into high yield savings accounts or other business ventures. Some examples of royalty income include getting paid royalties for a book, being in a TV show or movie, patenting an invention, or producing a song or other piece of music. The idea with this income stream is to create an asset that will bring in recurring royalties. 

For example, I’m an author of two traditionally-published books for which my publisher sends me royalties. You could write your book, release a song that gets picked up by a record label, or invent. The income stream could be a lifetime passive income stream, as royalties can have a long payment period. 

Passive Income Vs. Active Income

Your active income is when you get paid for your work. When you work at a job, you get a paycheck for hours and work you did. Business owners get paid by selling a product or service.

Passive income ideas require that you generate income through ways that don’t require an active effort. Passive income may not be 100% work-free all the time, but it can be once an initial investment of time or money is made. For example, you could invest money into the stock market, and any gains your stocks make would be passive income. You could also create and sell a product, such as a self-study program or membership, and generate passive income each month that way. 

Make Passive Income and Create Financial Independence

Making passive income is an exciting opportunity, but you’ll want to play the long game to create financial independence. Passive income streams are a life diversification strategy that helps ensure your income is consistent in case something happens to your primary income source. 

Decide which income streams make sense for you, then take action on creating a life in which your money compounds and builds generational wealth over time.