One of the easier ways to gain financial independence is to reconfigure your life so that a substantial portion of your income is not actively earned by your labor. To accomplish that, you will need to earn passive income. Passive income is money received that requires little or no effort to maintain the flow of income once the initial work has been done.
Does the idea of making money with little or no effort sound appealing? Here are the basics of passive income, including common sources, tax benefits, and strategies for achieving substantial passive income.
Key Takeaways
- Passive income strategies can include investing in a rental property, high-dividend stocks or REITs, and fixed-income investments like bonds.
- In addition to freeing up your time and finances, passive income may also be taxed more favorably than earned income.
- With a few exceptions, including royalties and patents, most passive income strategies require significant upfront capital, so many people work toward passive income goals while working a day job.
Why Seek Passive Income?
Passive income is attractive because it frees up your time so you can focus on the things you actually enjoy. Workers in most professions must continue to work the same number of hours year after year in order to earn the same amount of money and enjoy the same lifestyle. When you factor in inflation, those workers must receive pay raises or work even more hours to maintain their current income. Passive income supplements a worker's income from their job, allowing them to work fewer hours, stick with the same pay rate, or improve their lifestyle.
Everyone wants to retire someday, but it's difficult to stop working without passive income. Your income will cease completely unless you have some form of passive income. In the past, this was easily accomplished with participation in company-sponsored pension plans, but those are increasingly being phased out and replaced with contribution plans, such as 401(k) plans.
Tax Benefits
Aside from earning money without having to work, another major advantage of earning passive income is that it is often taxed more favorably than active income.
Many dividends from U.S. companies, for example, can be "qualified dividends" if you've held the stock for more than 60 days. These qualified dividends are taxed at the capital gains rate, which is usually more favorable than the standard income tax rate.
Note
As another example, a business owner who works for a company they founded may have to pay more in self-employment payroll taxes than someone who merely pays income taxes on their passive interest in that same limited liability company.
Common Examples of Passive Income
Anytime you receive money without performing a service or providing a good, you're earning passive income. There are many ways one can create passive income, but some of the most common examples include:
- Rent from real estateproperty investments
- Patent royalties for an invention
- Trademark licensing fees for characters or brands you’ve created in the past
- Royalties from books, songs, publications, or other original works
- Profits from businesses in which you have little or no day-to-day responsibilities
- Earnings from online advertisem*nts in a blog or on a website you own
- Dividends from stocks, REITs, equity mutual funds, and other equity securities
- Interest from owning bonds, certificates of deposit, money markets, and other cash and cash equivalents
- Pensions
Most Passive Income Requires Capital
While book royalties and invention patents are certainly ways of generating passive income, the average person may not have the time or skillset to pursue these means of income. Instead, most people will find that it's easier to make their money work for them—that is, use their money to generate ongoing passive income.
Some people may have access to capital through family money or funds from investors. Others will take the risk of borrowing funds to invest in assets.
Generally, the most common path to generating large passive income streams is to work at a primary job and use your actively earned income to buy assets that regularly generate passive income. While this strategy may not quickly result in substantial passive income, it can become a portfolio that generates substantial passive income over time, thanks to compounding, dollar-cost averaging, and dividend reinvestment. It can take many years to earn enough to truly improve your standard of living, but this is still one of the surest paths to wealth and significant passive income.
Reinvest Your Dividends
Your eventual goal is to use passive income on your daily expenses, but you won't reach that goal overnight. Until you're earning passive income you can live off of, it's best to diligently reinvest your dividends. This simple strategy can have exponential effects over long enough timelines.
All it takes to follow this strategy is to pay close attention to any dividends you earn on your current investments. Many stocks issue dividends. Blue-chip stocks and dividend ETFs are especially likely to offer steady passive income through dividends. When you receive a dividend payment (these are usually added to your cash balance in your brokerage account), then you should use those funds to buy more of the security that issued the dividend. The next time the security issues dividends, you'll receive more money, and you'll be able to buy more of shares in the security.
Note
This method doesn't only apply to dividend-issuing stock. You can use this strategy for any asset that issues steady payments, such as bonds, CDs, or money market accounts. The key is that, instead of spending passive income, you use it to earn more passive income in the future.
An investor who diligently reinvests their dividends will substantially increase their passive income. Eventually, they may find that they earn enough income through dividends to reduce their hours at work or splurge on extra luxuries.
