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How is residual income taxed?

        Money | Taxes

Residual income is the "set it and forget it" type of moneymaking.
Residual income is the "set it and forget it" type of moneymaking.
BananaStock/Thinkstock

It's been called passive income, recurring income, leveraged income, the best type of income and "the holy grail of investing" [source: Threetypes.com]. Residual income is the opposite of income that you actually work for, which is known as linear or active income.

Compared to the daily grind of earning active income, passive, residual income can come easy. When you own or create something that makes its own money while you are off doing something else, that money is residual income.

You don't have to be Paul McCartney to rack up residuals. You might own properties that you rent out even though you're not a Realtor. Maybe a blog you started took off, and while you no longer work there, you still collect part of the profits. Or perhaps you're a serial entrepreneur who creates companies and moves on. You, too, are earning residual income.

But the regular dividends from that stock that you inherited? Those don't go into the residual bucket.

It's an important distinction because the Internal Revenue Service pays attention to how your residual or passive income is treated on your income tax return. It turns out that some taxpayers try to fit income into the passive category as a way of offsetting and possibly deducting passive losses [source: IRS]. Don't try this at home.

You'll be better able to avoid that once you learn the difference between active and residual income, and how residual income is taxed.