What is passive income?
Wikipedia defines passive income as “income that requires little to no effort to earn and maintain.”1
NerdWallet defines it as “money generated from investments, properties or side hustles. The goal is to achieve a steady flow of cash without the daily commitment of a full-time job.”2
There are many different thoughts around passive income and I have spent a lot of time and effort to come up with my own definition; I define passive income as “anything that is not considered active income”... sorry. But my discussion below will hopefully give some insight as to where I am coming from.
There is a wide range on the spectrum of passive and active income, so there is no clearly defined line between the two of these. What I think individuals are really looking for is “how do I grow my money as much as possible with the least amount of effort?” Great question, but needs a lot more clarity.
What I want to illustrate is everything takes a certain amount of work. Although not linear, some income streams may require more effort with the potential of a larger financial gain. There may be some “internet gurus” bragging about how easily they are making $50k per month on their YouTube channel, but it took them a lot of effort to get there, and continued effort to maintain it. Not to mention the upfront and continued costs of that operation - they are not taking home nearly that amount of income.
I am going to break this into three main categories: active income that takes a lot of effort, semi-passive income that takes some effort, and passive income that takes little effort. In my opinion, you have to become an investor to make passive income, and becoming an investor starts with your active income.
Active Income, a lot of effort
This is a full time job, whether that be working for an employer, running a business or running a few businesses. This should be a job that one is an expert at doing and spends most of their time. For me, this is financial planning and tax planning.
In my opinion, active income is most important in building wealth. If someone becomes the expert in something or really good at a skill, people will pay them to do it. The better they are, the more people will pay them for it.
If they spread themselves too thin and have a few unrelated side hustles, they may not be building as much wealth. There will be more streams of income, but if all these streams combined do not add up to the earning potential of focusing on one job, then it is less effective in building wealth. From my experience, individuals find the most success in focusing on and growing the stream that they are the best at performing and enjoy the most.
As a side note, this is not to discourage a side hustle. If you enjoy doing it or want to make some extra money, I would never discourage that. I just want to make the point that more income streams does not correlate to more income.
Passive income almost always requires upfront capital. In other words, an individual has to make active income and save some of that money to have access to passive income. Once active income is made and money is saved to start a nest egg, this nest egg can be used to become an investor and begin making passive income. Below are a couple ways in how to become an investor.
Semi-Passive Income, some effort
As I mentioned, I see the different types of income on a spectrum, so “some effort” lands in the middle of the spectrum. Growing money will always take some form of effort, and putting in more effort has the goal of acquiring a larger income stream.
The best example I can give of “some effort” is rental real estate. Owning a rental property is often seen as a passive activity, but there is a certain level of effort needed to be an investor in real estate. For some people, this is a full time job! It is not as easy as “buy rental property, receive rent payments”. Some of the effort that comes with owning rental real estate includes:
Added cash contributions for costs including mortgage payments, insurance, property taxes, maintenance, etc.
Finding, screening and retaining tenants.
Researching the state’s Landlord/Tenant laws to remain compliant (or hiring someone to do this, adding costs).
Drafting lease agreements to ensure protection, which may require hiring a lawyer and adding costs.
Optional liability protection beyond insurance, for example setting up an LLC and opening bank accounts in the name of the LLC.
Added tax return complexity with the filing of Schedule E, depreciation expense on the property, and bookkeeping to keep up with allowable deductions to offset your income. This may require hiring a tax preparer, again adding costs.
There is the option of hiring a property management team to control the managing of the property, but again these are added costs that eat into the profits, and do not take away the financial risks associated with the property. This is when people say “my rental properties make me $5k per month” but their cost to run those properties may be $4k per month - make sure to understand the effort that will go into the activity, or the costs of outsourcing that effort to somebody else to ensure the investment is worth making.
Real estate can be a great way to build wealth due to income from rent payments received on top of value increases on the home. But getting that potential extra return may require more effort, thus making this less “passive” than other options.
Passive Income, minimal effort
Towards the end of the spectrum, there are some options that take less effort. It may result in a lower financial return, but it requires less effort which allows more attention to your active income.
A great example of “minimal effort” passive income is investing in a mutual fund or ETF. The barrier to entry in this type of investment is low. Once a share of a mutual fund or ETF is purchased, there is little required ongoing effort. This is not to discount the effort it took to decide which mutual fund or ETF to invest into, and it may be prudent to monitor any investment made, but it is not required. Unlike ongoing costs that are associated with rental real estate, no additional investments into a mutual fund or ETF are needed. Investing in the stock market may lead to filing Schedules B and D on your tax return which may add costs to hire a tax preparer. There is no responsibility to track income and expenses like there is with real estate, as the bank does this and reports it with a tax statement at the end of the year.
There is risk to any investment, as there is no guarantee that the mutual fund or ETF will provide any income or increase in value. There is real risk of losing capital and an investor should understand all the risks that come with investing before deploying this strategy. Past performance is not a guarantee of future results.
The strategy I most often implement is a “buy and hold” strategy, which means once I invest, I am expecting to hold on to that investment for the long-term (10+ years). This type of strategy leads to less effort, as I am not actively researching, buying and selling different investments.
There are other stock market investment strategies that may require more effort, but this is beyond the scope of this blog. If this is something you are interested in, reach out to a professional for more information.
It takes time and discipline to build wealth, and money only comes with effort. There is no “get rich quick” formula, and although passive income sounds very appealing, it takes time and effort to become, and continue to be, an investor receiving passive income.
To start receiving passive income, begin with active income. Become an expert and increase your earning potential. Spend less than you make and grow a nest egg.
Once you have the nest egg, you can become an investor. Set your expectations that it is going to take time, but the best time to start is now. Do a little bit at a time, and if you are consistent, you will thank yourself down the road. Do what you know or what you enjoy, or hire somebody to help you get started.
Below is a chart of how compound interest works - this illustrates putting the same amount into a bank account each month and achieving a 5% return year over year. As time goes on, your money compounds and grows on itself, creating a “snowball effect”. The building starts slow, but no matter when you start you are going to have to get through those slow years - why not start now and enjoy the rewards sooner rather than later?