Most people dream about being financially independent, but only a certain type of person actually achieves this goal. They don’t know enough about personal finance to realize that the best way to achieve this financial independence is to create a source (or many sources) of passive income. This means that you receive income even though you’re not working to earn it (or only working a little bit).
Here are some of the most often-utilized sources of passive income:
- Rental income from real estate properties
- Royalties from a creative work like a book or song
- Businesses with a “set it and forget it” mentality. A good example of this is a paid parking lot. There are plenty of unmanned parking lots that utilize a locked box to collect payment, or have a kiosk to pay via credit card. The only work you would have to do is to clean it up every once in a while and then collect your money!
- Letting companies place advertisements on your blog or website
Why Passive Income Trumps Active Income
Well, in one word, FREEDOM! If you set your finances up in a way that you earn income without having to keep a full time job, imagine what else you could be doing with that time. You could spend it doing things you actually want to, such as travel or volunteer.
If you are only earning your incomeby working at a job, your money typically goes to normal day to day expenses. This means that you will have to continue working indefinitely to be able to afford your lifestyle. You may have a great career, but if you didn’t have to work, would you? Think about the sacrifices you make every day. You miss out on time with your family. You aren’t able to go where you want, when you want. You might even put off important medical visits because you don’t want to take the time off of work.
The worst part is that when you decide it’s time to retire or if you are permanently disabled, you will no longer have that income from working. Without that income, you won’t be able to support yourself without help from family or the meager assistance provided by the social security program.
Two Categories of Passive Income
Passive income comes in two categories, and the one you utilize more will depend on where you are in your career, your personality, your financial situation and your talents and skills. These two categories are the types that require capital up front and the types that don’t.
If you choose the kind that needs capital up front, you’ll either have to use family money, money from investors, or a bank loan. Bank loans involve going into debt and therefore increases risk. For example, someone who wants to buy rental properties may take out loans to purchase the homes up front and then rely on the rental income to repay the mortgage. The problem with this is that if you aren’t able to gain enough income to repay the loan, you could lose everything.
Another example in this category is a person who has a large portfolio of investments. Owning $10,000,000 worth of stock with a $500,000 yearly dividend payment sounds wonderful, but you would have to put that money in up front, and that $10,000,000 is untouchable as long as you want to continue collecting those dividends.
The other type of passive income which does not require capital up front is far better for those people who want to build wealth from scratch. Things like creative works (books, songs, patents, etc), websites, and some “set it and forget it” businesses fall into this category because they require little or no investment up front, but can provide large returns.
The Most Travelled Path to Passive Income
Most people who aspire to earn passive income have careers, and use money left over after living expenses are paid for to purchase assets that are expected to generate passive income later.
For example, a doctor might use his income to purchase shares of medical or pharmaceutical companies he is familiar with, or put that income towards investing in a medical or pharmaceutical start-up company. In time, the compounding, reinvesting of dividends, and utilizing the dollar cost averaging technique will produce a substantial amount of passive income. Unfortunately, this way, it might take decades for your investments to begin producing enough passive income to passively support your standard of living, but it’s historically been the most reliable way to become wealthy.
Tax Implications of Passive Income
Passive income usually has more favorable tax implications than active income. While this is typically seen as being unfair, it is supposed to motivate people to invest, which will prompt economic growth and job creation.
An example of this is someone who is the owner and employee in his own business would be liable for self-employment taxes on top of regular income taxes, however someone who has investments in the same company, without being an employee, would only pay income taxes on returns. So, the same income would be taxed higher for the business owner that actively works than it would be for the investor, who only collects passive income.