Imagine if you could make money just by sitting down and doing nothing. Believe it or not, this is something countless people do every day. This money that you earn with little or no effort is known as passive income, and it gets you on the fast track to Financial independence.
Making money without working for it might sound too good to be true, and there is a catch. Passive income does not materialize on its own; it requires an initial investment of money and time. The first step to accessing passive income is to buy, create, or contribute assets that produce cash flow. If all goes as planned, your reward for that initial investment is a continuous stream of income that you can enjoy over time.
Keep in mind that the IRS has a narrower definition of income from passive activities. For the purposes of your income tax return, special tax rules apply if the income is from the rental of equipment, rental property, or a business in which you do not materially participate.
Benefits of passive income
Passive income is an essential part of financial independence. Compare passive income to the money you earn in a paycheck, and you can see why.
Your work income depends on your presence and your daily tasks. It’s limited in many ways: by the number of hours in the day, your health, your age, your company’s policies on raises and promotions, and even your boss’s perception of your performance. Even when you are healthy and able to work, there is a limit to what you can earn. And, if your health deteriorates, so does your earning potential.
Passive income does not have these limits. You can earn passively at any age and in any health condition. A greater flow of passive income makes you less dependent on your salary and gives you more freedom to choose how you spend your time. Passive income can fund large financial goals, such as retirement, or smaller, such as debt repayment.
Types of passive income
As noted above, you can create a passive income stream by buying, creating, or contributing an asset that generates money.
- To buy: Passive income investments include dividend stocks, obligations, annuities and rental property. You can also buy a small business.
- To create: You can develop a product or a service that generates money.
- To contribute: You can invest in an existing business or in a limited partnership. You can also make available for sale or rental a property that you already own. Renting a room in your home is one example.
Where to invest to create passive income?
The easiest place to start investing for passive income is in a standard brokerage account. You can access a variety of income producing securities including stocks and bonds or dividends mutual fund, exchange-traded funds (ETFs), and real estate investment trusts (REITs).
By investing in a individual retirement accountLike a traditional IRA, has the advantage of tax-deferred investment income, in a taxable account you will pay taxes on that income even if you reinvest it.
You can also invest directly in rental properties or commercial businesses.
What are the most popular ways to generate passive income?
Popular passive income strategies fall into three general categories:
- Traditional Income Investments: Fixed income and dividend paying securities are popular sources of passive income because they require very little work. You do the research up front, monitor your investment portfolio and collect your payments. If you don’t need cash immediately, you can reinvest those dividend or interest payments to accelerate your income growth.
- Rental buildings: Owning real estate for rental income is also great because you can finance the property inexpensively with a mortgage. Also, the value of the property is not as volatile as the stocks. The tradeoff is that passive income from real estate is often less passive than you might think. Unless you hire a property manager, you will coordinate maintenance and repairs, answer questions from tenants, and collect rents.
- Online businesses. Those who are short of cash are often looking to start a small business that will eventually produce passive income. There are plenty of opportunities in the digital space, from e-commerce stores that deliver product to blogs and online courses. This is a longer term strategy as these businesses are often resource intensive at the start.
Does passive income really require “no work”?
Passive income takes work. However, much of this work is done early on so that you can enjoy the cash flow later with less effort. The amount of work involved will vary depending on the passive income strategy you are pursuing.
Invest in a reputable company dividend shares, and you don’t have to do much at all. Just watch your position and you could get a 2% or 3% return on your investment for many years.
As you seek higher returns, the amount of work may increase. You could invest in a high yield income fund that uses leverage and other aggressive tactics to amplify returns, for example. This is a position that should be managed closely as it will likely be quite sensitive to market and economic trends.
Starting a small business, which could have unlimited return potential, usually requires even more time and energy. You could be putting in full-time hours for months before the business is stable enough to allow you to step back from the front lines.
How to pay tax on passive income?
It probably won’t surprise you: Taxing passive income is confusing. There are several sets of rules and exceptions that apply, depending on the exact nature of the income.
For example, ordinary dividends are taxed like ordinary income, but eligible dividends are taxed at the long-term capital gains rate. Rental income from real estate is also taxed as ordinary income, but you can deduct your mortgage interest and other expenses as well as depreciation. Income from a business you run is often subject to ordinary income tax, plus self-employment tax.
There is also a special set of rules governing the tax treatment of losses on passive activities. This is where the IRS’s definition of “liability” comes in. The little story is that losses from passive activities cannot offset your regular income. You must either carry these losses forward or offset them with passive income in the same tax year. This only applies if your income is from the rental of real estate, equipment leasing, or a business in which you invest but in which you do not materially participate.
Your ticket to financial freedom
Passive income is your ticket to financial freedom. Get enough of it and you can do whatever you want with your time while paying your bills.