Passive Income

What is passive income?

For most people, passive income refers to revenue that comes without day-to-day operations requiring active work. However, a taxing authority, like the IRS in the United States, might have a different definition. 

The IRS taxes passive income differently from earned income and portfolio income. However, when discussing passive sources of income, most people don’t have the IRS definition in mind. Instead, it’s about building up revenue streams that can be relied on later, no matter how they’re taxed.

No matter where you live, check the taxation rules for passive income to know how it will be handled. Then, if you’re hoping to create your own passive revenue sources, read on to learn how.

What examples are there of passive income?

There are various ways to build passive income streams. Many successful investors cultivate multiple revenue streams over time. Here are some ideas you can consider.

Buying and holding main stock market ETFs

Many major stock market indexes have ETFs based on their performance. On top of that, many of these ETFs pay dividends, which can be a way to build passive revenue. Some examples of these types of ETFs include the Stoxx50, S&P 500, and the FTSE 100.

It’s worth noting that the FTSE historically offers relatively high returns — including paying more income than some other market indexes.

Dividend stocks

Some stocks pay dividends to shareholders. If you build a dividend portfolio with stocks and indexes that pay a portion of profits to shareholders, you could create a passive revenue stream. 

One way to build your dividend portfolio is to reinvest the dividends you receive initially. Then, each time the stock pays a dividend, use the money to buy additional shares of the stock. Because companies base payouts on the number of shares you own, you’ll see more significant dividends over time. Later, after you’ve established your dividend portfolio, you can use the payouts as a passive income stream.

Bonds

Bonds represent a loan to another entity, like a company or a government. You don’t own a piece of the company as you would with a stock. Instead, you receive interest payments at regular intervals. Once the bond matures, you receive the face value back.

You can create bond ladders, where you reinvest the funds when you receive your original loan back. You can also invest in bond funds and bond ETFs. ETFs offer access to various bond instruments and receive regular income or dividends as a result.

Buying and renting out real estate

If you can purchase property, you can rent it out and receive income. Using this strategy would charge more for rent than the monthly mortgage payment. The renter covers the mortgage with their rental payment, and the remainder flows to you as income.

It’s possible to do this with single-family homes or buy multi-family units, such as apartment buildings. Another way to generate passive income through rentals is with house hacking. In this strategy, you buy a duplex, triplex, or fourplex and live in one of the units while renting out the others. As a result, you have a place to live, generating passive revenue for you.

Buying REITs

Maybe you aren’t interested in becoming a landlord, or you can’t purchase a rental property. If that’s the case, investing in a real estate investment trust (REIT) can be a way to generate passive income in the form of dividends.

REITs pay shareholder dividends regularly. Additionally, REITs must pay out 90% of taxable income in dividends with REITs. In this case, you can benefit from REITs by buying shares and using them as part of a dividend portfolio that provides regular income.

Interest on cash

If you have a large pile of cash, you can earn passive income from the interest you receive for keeping it in an account. Recently, due to a low-rate environment, yields have been pretty low. However, with interest rates rising again, cash instruments may begin seeing better returns.

Certificates for Deposit (CDs) can provide relatively high yields, even though they are currently near historic lows. In addition, savings accounts are starting to see increases in yields as interest rates rise. With the Bank of England and the Federal Reserve raising rates, other cash vehicles will likely begin growing, providing the potential for passive income.

Start a business

Another way to generate regular revenue is to start a business. Later, you can hire others to do the active work associated with the business. 

Starting a business can be time-consuming at first. If you’re successful, though, you can offload some of the work, and the income becomes passive.

Creative endeavors

It’s possible to make money off your creativity. Writing, performance, music, and other creative efforts can be monetized. In addition to YouTube and streaming service, Patreon and Twitch can monetize your creativity. While your efforts are active at first, they can start generating steady income over time.

Cryptocurrency yield farming

While cryptocurrencies and other digital assets are taking a hit right now, there are still some opportunities. For example, if you believe in a cryptocurrency, you could potentially earn money by locking your coins up in a liquidity pool through yield farming. You receive regular payouts (in crypto coins) when others use your assets for transactions simply by letting them sit there.

What is the attraction of passive investing?

“Make money while you sleep” is a massive draw for many people. Here’s why developing passive revenue streams can be so attractive.

1. Regular income over time

Passive investing rarely results immediately in life-changing income. However, as you build up the revenue stream over time, it can result in regular income. Whether it’s a rental property or dividend stocks, the more you build, the bigger your income later. Use this steady income to fund daily expenses or set it aside for emergencies.

2. Less work as passive income grows

Most passive income streams require time and energy at first. Building the revenue streams can be work-intensive. However, as your income increases and the investments start paying off, you can work less. Even investing in dividend stocks or index ETFs can require research and time to get started. However, as your portfolio builds or your business grows, you spend less time managing and more time enjoying your life.

3. Reduced income risk

Having multiple revenue streams reduces your overall income risk. When you rely solely on a job, there’s the potential that you could lose your career — and your income. When you invest passively or cultivate different revenue streams, you diversify where your money comes from. That way, if one stream is reduced or disappeared, you have other sources of income.

4. Ability to always be making money

On top of having access to different income streams, you are also always making money.  Even if you aren’t actively participating in the money-making activity, funds come in. At a job, you’re only making money while you’re working. However, once you get a business going, or if you’re investing in dividend-paying assets, you’re making money even if you aren’t being active. You can make money 24 hours a day.

5. Potential simplicity

Depending on the route you choose, passive investing has the potential to be simple. You can choose index ETFs, which are transparent and easy to invest in. If you buy a triplex, you can be on-site and have a place to live while your renters cover the costs and bills through their monthly payments. You have the ability to keep things simple while bringing in money.

How can a novice investor take their first steps to passive income?

When developing passive revenue streams, it’s important to start small and grow gradually. Here are some ideas for taking your first steps.

Expand on an area of expertise or passion

Look into something you’re interested in or already know about. If you want to start a business or monetize a hobby what you already know can be a good place to start. You have some basis in the market and what it takes to be successful. This can be a way to dip your toe in and begin making money.

Do not take too much risk

Be mindful of your risk tolerance. Understand that you want to start small and avoid putting too much capital into something risky. As you learn and grow, you can put more capital into the passive investment. Start small to learn how investing works and understand how to spot future opportunities.

Get some education on the investment

You don’t have to know everything about it to get started. However, a small bit of knowledge can help you make better decisions as you start investing. You can buy a respected course, read blogs and books, or get a mentor. It can be useful to learn a few things before you start putting money into an investment.

Pros and cons of passive investing versus stock trading

Passive investing, which consists mainly of using index products can provide you with a relatively easy way to grow your wealth while seeing regular income.

Pros

Passive investing can be less risky

You face fewer risks when using passive investing strategies than with stock trading strategies. Because you’re investing for the long-term, you’re likely to have long-term success if you stick to your strategy. On the other hand, with day trading, only about 20% of investors make money in a six-month period.

Passive investing can be less stressful

Active stock trading can be stressful. You have to spend a lot of time watching the markets. You must make sure you enter and exit your trades at the proper times to be successful. Day trading comes with a great deal of stress — and it takes up a lot of time. Passive investing doesn’t take up time each day and you don’t have to worry about short-term price volatility. Indeed, there’s less stress because, over time, the stock charts smooth out, and the stock market as a whole hasn’t lost money in any 20-year period.

Reinvestment has powerful compounding impacts

When you reinvest the income (or dividends) you receive from a passive income source, that increases your ability to compound over time. Not only do you grow your portfolio, but there’s greater capital appreciation potential. As you use your income to buy additional shares — especially if you can get them at lower prices — you can boost what you have overall.

Cons

There isn’t instant gratification

With day trading, you can enjoy instant gratification with your “wins.” Passive investing takes longer for you to see dramatic returns. Day trading allows you to potentially see big returns in a short period of time.

It can be hard to sit through a down market

Passive investing requires that you stick to your strategy during a down market. It can be hard to resist the urge to sell your assets during a crash. The last thing you want to do as a passive investor is to lock in losses during a market correction.

Not as exciting

Stock trading can be exciting, while passive investing is often seen as boring. If you’re interested in having more fun with your investment portfolio, and you have the risk tolerance for it, you might find stock trading more fun. 

What are the risks with passive income?

Even though passive income can be attractive, there are risks involved. Understand the potential risks before you start building your passive revenue streams.

The asset you base your income on could lose value

Any type of investing comes with risk. The asset you rely on could lose value, reducing — or potentially ending — your income. Real estate can lose value or a competitive housing market could mean lower rents. A dividend-paying stock could cut its dividend or stop paying a dividend altogether. A book you publish could see diminishing royalties or your website business could stop producing over time.

Interest risk

Some passive sources don’t offer enough yield to help you keep up with inflation. Cash and bonds might offer income, but your purchasing power is reduced over time due to inflation. 

Over-reliance on one passive income source

Finally, it can be tempting to rely heavily on one source of passive income. Rather than relying too much on one source of income, it can make sense to diversify. That way, if a dividend stock cuts its dividend, you might still have revenue coming from your business or from a rental property.

What is the criticism of passive income?

While passive revenue can contribute to financial independence, there are some criticisms. 

No income is truly passive

First of all, critics often point out that no income is truly passive. You often have to take steps to build the income in the first place. Additionally, you might need to take some actions to keep the income flowing. Maybe you need to rebalance a portfolio, manage rental property, or keep a website updated.

You can’t always control passive income

It’s not always possible to control market outcomes that can impact your passive income. Even if you build up the passive income, it could disappear, or your income could be reduced due to circumstances beyond your control.

5 tips for profiting from passive income

Once you decide to build passive revenue streams, you need to make sure you can profit. Here are some tips to help you along the way.

1. Start small

Don’t wait until you’ve saved “enough” to begin investing or working on passive income. Start small, buying shares of an index ETF or starting a side business that you can work on a few hours a week. Small steps can eventually show big results, especially if you’re consistent.

2. Be consistent

When building a passive investing portfolio, consistency is key. Regularly invest and then reinvest the dividends whenever they’re paid. Over time, that consistency can help you build up your passive income. This works whether you’re building a website, selling a course, or creating a long-term dividend portfolio.

3. Reinvest your income during the early stages

Because building passive revenue streams can take time, it is important to reinvest. When you earn income — no matter how small — from a venture, reinvest it. This will allow you to put more resources into building the revenue stream. Over time, the compounding effect and your ability to earn more income will deliver the desired results.

4. Recognize this is a long-term effort

Understand that passive income is the result of a long-term plan. For most people, it takes time until the passive revenue streams provide enough regular income to live on. Create a long-term strategy and stick to it.

5. Understand that passive income starts with work

Because of the name “passive,” many people don’t realize that there’s some level of work. Building passive revenue streams takes effort. You might need to research different stocks, understand how real estate works, be a landlord, or maintain a website. If you’re making passive income from royalties, you had to work to create your intellectual property. Before you jump on the passive revenue bandwagon, make sure you know how much work you actually need to do.

Passive income: general terminology

Alternative income: Money received from sources that are considered non-traditional, such as running a side business or getting it from an alternative investment source, such as yield farming with cryptocurrencies.

Earned income: Money received by doing active work. This can be work through a job, running a business, or from some other source of active involvement.

House hacking: A passive income strategy that includes living in your property while making money from rents. This can include buying a home and renting out rooms or buying a duplex or fourplex. With house hacking, you live on the property, but your expenses are paid by the tenants that you have.

Interest income: Money received as a result of being paid the interest you’re owed. This can be interest from cash vehicles like savings accounts and CDs, or from loans you make, such as bonds.

Material participation: A tax term that indicates what activities are considered “participation” in a business or income-generating venture. For example, if you make money from a rental property, it might not be considered passive for tax purposes unless you aren’t involved in day-to-day operations.

Passive income: Money that is received even when you aren’t actively working for it. This can include investment or business income. Your taxing authority might have a specific definition for tax purposes, including differentiating passive income from investment or portfolio income.

Real estate investment trust (REIT): Type of company that invests in real estate projects. It’s required to pay out at least 90% of its taxable income in dividends to shareholders.

Conclusion

There are several different ways to generate passive income. However, it i’s important to understand that all passive revenue streams require time and effort to build up initially. Additionally, some revenue streams require some level of work to maintain over time. 

Carefully consider what income streams are likely to work best with your knowledge and time availability and create a plan to build up income streams so that you can achieve financial independence.

FAQs

What’s the easiest passive income?

In general, you’re likely to have the easiest time with passive income when you build a portfolio of investments that pay dividends. This can include index ETFs, dividend stocks, and REITs. With this strategy, you can automatically invest on a regular basis and reinvest the dividends. Over time, your stock portfolio grows to the point where you can eventually live off the dividends.

How much labor does passive income involve?

Almost any passive revenue stream requires some degree of labor to get started. This can include building a business, which can be labor-intensive. It might be research to find out what stocks to buy. Different revenue streams require different levels of labor to start.

What is the highest paying passive income?

Yield farming with cryptocurrencies offers some of the highest passive revenues. However, it’s also very risky, since crypto prices are volatile and can crash. Rental property, especially if you have multiple units, is also considered a high-paying passive revenue source.

What can someone do to research how to earn passive income?

There are many blogs, websites, books, and courses designed to help people learn about building different income streams. Beware of fake gurus and look for good information from someone who has had success.

How do you make passive income low risk?

The lowest-risk passive income comes from dividend-paying index products. You can invest in stock index ETFs or bond funds. These products build passive income over time with relatively low risk.