People and businesses receive income when they provide a service or when they make an investment. Passive income and residual income are two types of income. However, they are fundamentally different. Passive income isn’t necessarily residual income, even if it is passive.
An enterprise that generates passive income is one that requires little or no ongoing effort. After paying their bills and meeting their financial obligations, residual income is a calculation that determines how much discretionary money they have left to spend.
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Passive Income
Individuals and companies often earn passive income without much efforts, such as investments or peer-to-peer (P2P) lending. As defined by the Internal Revenue Service (IRS), it is income earned from an entity with which you have no direct affiliation.
A large passive income can free up an individual’s time to do other things other than work. In addition to offering increasing levels of financial security, it is risky when establishing the mechanism for passive income.
If it provides steady cash flow, passive income can provide significant security because the income is not dependent on your time. Having an extra source of income to supplement income is still nice, even if it isn’t enough to quit your day job. If you have a lot of debt or a dependent gets sick, you may even have a better quality of life by moving more of your income to a passive source of income.
The profit generated from a rental property owned by investors who are not actively involved in managing it is an example of passive income. An annual dividend-producing stock is another example. The stock must be purchased by the investor to realize passive income, but there is no other effort required.
Residual Income
Passive income is income earned by entities without exerting any effort on their part. In the world of personal finance, corporate finance, or equity valuation, it may mean very different things.
Here is a brief look at how each region views this type of income.
Personal Finance
After all personal debts and expenses have been paid in personal finance, residual income is the remaining income. In order to determine the creditworthiness of a potential borrower, residual income is used.
A bank compares residual income to the cost of living in an area when determining whether applicants can afford a mortgage. The bank subtracts the applicant’s monthly income from the mortgage, insurance, and taxes paid, as well as payments for credit cards, installment accounts, and student loans. The remaining amount is considered residual income, which does not include food and utilities.
Corporate Finance
Corporate finance also refers to residual income as the excess of a company’s net operating income over its required rate of return. This is the profit left over after all capital expenditures are incurred. In general, residual income is used to assess a company’s capital investment or the performance of its business units.
Equity Valuation
As far as equity valuation is concerned, residual income is the method used to estimate a stock’s value based on an economic earnings stream. Using the residual income valuation model, the book value of a company is equal to its future expected residual income. The cost of net capital is subtracted from net income to arrive at this figure.
Residual income is the net income generated over the minimum rate of return used in valuing investments.
Special Considerations
The concept of passive income is sometimes used interchangeably with residual income or the money you earn without exerting much effort. However, the two terms can have very different meanings. Your residual income, for example, is calculated by the profit you make after paying all of your bills. The residual income you have as an individual after you pay your debts and financial obligations like a mortgage or rent, and any other debts, is what you have remaining.
In terms of earning money on a regular basis from stocks, royalties, or rental income, residual and passive income are similar terms. An individual or company’s circumstances determine passive income versus residual income.
How To Create Residual Income?
Creating residual income is relatively easy. You can rent out a room or your house on weekends, sell your photographs and crafts online, or learn about stocks and peer-to-peer lending opportunities.
How Are Passive Income and Residual Income Taxed?
The amount you pay in taxes on passive and residual income depends on numerous factors, such as whether the income is from financial transactions or real estate.
What Is Active Income?
Active income comes from salary, hourly wage, tips, and commissions. An active income is an income that comes from performing work related to your job or career and getting paid for it. You must put in the time to earn an active income. Passive income is earned without exerting much effort.
Final Words
There is a difference between passive income and residual income. You can use residual income to support a stream of passive income after you pay all of your bills. The idea behind passive income is that you can earn money while putting very little effort or time into it, such as earning dividends on stocks or renting a vacation house.
When you make a profit from a passive income stream, you can use the residual income to develop a new passive income stream. You may be able to benefit from investing in a passive income endeavor if you are able to afford the startup costs.