What is Passive Income?

Everybody knows that money doesn’t grow on trees, but it is possible to earn money without having to work for it. This “free” money is called passive income, and most people earn it in various ways and to varying extents. Passive income allows many workers to reach their financial goals to retire on time, and it also helps create millionaires or even billionaires.

What is Passive Income?

Wikipedia defines passive income as “income received on a regular basis, with little effort required to maintain it.” Active income, on the other hand, is money that is earned after working for it. Why not rely on passive income? Well, passive income stems from active income.

Here is an example to show the difference. Active income would be compensation after mowing a lawn while passive income would be the interest earned on that money in a savings account. You had to initially work to earn the paycheck (active income), but the bank rewards you with interest (passive income) for keeping your money in a savings account. Passive income results from your active income going the extra mile (hence the example: lawn money goes to savings account for interest, otherwise called an income producing asset). 

Benefits of Passive Income

There are many benefits of passive income, and several of these are described below.

More Money for Retirement

If you invest in the stock markets, you have most likely heard about compound interest, or capitalized interest. Rumor has it that Albert Einstein called compound interest the greatest invention. This is because you can earn interest on previously paid interest and dividends. For example, if you own a stock that rewards a 5% dividend each year and you reinvest the dividends, the dividend you were rewarded last year will also earn 5% interest. Over the course of many years, these increasing dividends can turn into a small fortune. Assuming the same rate of return, a 25-year old that invests $5,000 per year for 10 years and stops contributing for the remainder of his life will have more money than a 35-year-old who invests $5,000 per year for the next 30 years due to compound interest!

If you just graduated from college and have student loans to repay, do be intentional and try to set aside at least 10% of your income for retirement. If you cannot contribute 10%, do contribute as much as possible even if it’s only $50 a month. Your first decade in the workforce might be the most financially challenging as you establish a career and repay student loans, but, your contributions during this timeframe have the greatest opportunity to accumulate in value and passive income.

Passive Income Works When You Don’t

With your regular job, you only make money when you work. If you are sick, take a vacation, or quit, then you do not earn a penny until you return to work. Passive income accumulates every minute of the year. While you sleep, your investments and savings are still earning money. It might not be a large amount that will allow you to quit your job today, but it’s nice to know that you are getting richer by the second.

Passive Income Has Lower Tax Rates

Dividends (capital gains) paid by stocks and mutual funds are taxed at a 15% rate for most American families. Passive income is taxed at lower rates than the active income you earn at a regular job. As an additional benefit for 2017, there is the possibility that the capital gains tax rate will lower a few percentage points in the upcoming tax code revisions. Lower tax rates are one reason that the “Buffett Rule” was introduced. For instance, legendary investor Warren Buffett stated he was taxed at a lower rate than his hired employees because most of his income is passive income.

Passive Income Allows Flexibility

If you have a steady stream of passive income from investments, owning rental properties, or peer lending, this means you can use the income streams to supplement your current lifestyle and find a less stressful day job. Many people work an undesirable job because they need a high salary to pay the bills. By having a reliable passive income stream, you might have the ability to find a job that complements your skills even if it pays less than your previous job. If the passive income can counter the salary difference, you essentially “break even” and earn the same amount of money each month but have a better quality of life.

Negatives of Passive Income

While there is much good that comes along with passive income, there are some downsides as well.

Passive Income Fluctuates With Interest Rates

For those that are retired or nearing retirement and depending on passive income, poor financial market conditions can wreak havoc on their portfolios. Historically low-interest rates have made it very difficult for individuals and pension funds to grow at projected rates. Instead of keeping money deposited in a low-risk savings account that paid 3% or 4%, retirees and pension funds need to invest in riskier assets to earn a similar rate of return. Riskier investments often mean higher amounts of passive income in good times, but it can mean larger losses in bad times. Just like your active income might vary on the state of the economic climate, passive income has bull and bear cycles as companies and banks adjust their dividend rates.

Passive Income Needs Diversification

Not every form of passive income is the same. Savings accounts and money market funds currently have some of the lowest payouts and investing in stocks will have the highest returns. Another form of passive income is owning rental properties and you earn passive income each time your tenants pay rent. But, if the rental property is unoccupied, you do not earn rent (passive income) that month. To ensure that you have a steady stream of passive income, it is recommended to own a broad basket of assets that pay passive income throughout the year so you at least earn some income regardless of the market conditions.

Passive Income Requires Initial Investment

Just like there isn’t a “free” lunch, passive income also requires an initial investment. The old adage “You need to spend money to make money” still rings true. You will not earn passive income by keeping every spare penny hidden underneath your mattress. It needs to be deposited in a savings account, investment portfolio, or in tangible assets like rental properties that can earn money once the initial cost is recouped. You will also need to do periodic maintenance to ensure you are still maximizing your passive income streams. That might mean readjusting your stock portfolio to choose new funds that have lower fees or higher dividend payouts. For rental properties, it might be installing a new roof or fixing a dripping faucet. Anything that generates passive income should be held for its long-term benefits, not the initial and recurring costs. But, you must take the costs into account to determine if the potential long-term payout is a good return on investment.