Passive income is generally defined as income that comes from investments or business interests that require minimal effort. You don’t go to work each day to earn passive income, although managing your investments may still require work. Retirement, however you define it, is achieved when you don’t have to work to earn a living, but instead can count on reliable sources of passive income.
How to Build Sources of Passive Income
Most people build up sources of passive income over time by working, then saving and investing some of what they earn. They build up their savings and investments to the point where the investments generate enough income that they can retire and then just manage their investments or businesses.
The book "Rich Dad Poor Dad" does a great job of helping you understand the difference between working for a living at a job versus working toward building a business and an investment portfolio that can generate ongoing passive income.
Once you have investments, you have to learn to manage them so they generate reliable passive income. In retirement, it is best to follow a disciplined set of investment management rules to make sure you don't withdraw too much too soon and thus jeopardize your future income.
Passive Income Mistakes
One of the mistakes people make when planning for passive retirement income is thinking they can put everything on autopilot. Managing investments—whether in the form of mutual funds, retirement accounts, businesses, or real estate—takes time. You can hire good people to help you, but you still need to keep tabs on those people and on the work they are doing.
Cognitive abilities can decline rapidly after age 65 without you even being aware that it is occurring. For this reason, it is important to have advisors and family members you trust. Share your passive income strategies with relevant people you trust and know will look out for you.
How to Earn Passive Income in Retirement
From a business: If you are looking for ways to build a business, start by evaluating the areas where you have both experience and passion. You may go back many years to things you did when you were younger and find that an old hobby combined with years of business experience can turn into something exciting and lucrative. This process can help you find business ideas that leverage the skills you already have.
From investments: Learn as much as you can about how to invest for income. Each type of investment—such as interest income from bonds, dividend income from stocks, retirement income mutual funds, high yield investments, and annuity income—has its own pros and cons. There is no such thing as a perfect investment, so mixing up a portfolio with many different choices is usually the best approach.
From rental real estate: Creating passive income through rental real estate can be an effective strategy, but you need to do your homework before heading down this path. Successful real estate investors look at it as a business, not as a get-rich-quick plan.
From a network marketing business: Many network marketing businesses, also called multi-level marketing, tell you their business model is a great way to build passive income. People can have a tremendous amount of success building these types of businesses, but there is nothing passive about it initially. Like building any business, it requires lots of hours and hard work. Numerous network marketing businesses have come across as scams, so be careful and make sure the business is legitimate. Companies such as Avon and Primerica are network marketing businesses that people have found to be lucrative and successful.
Tax Definition of Passive Income
From a tax perspective, there is a more technical description of passive income. The IRS categorizes passive activity as any rental activity or any business in which the taxpayer does not materially participate. By their definition, passive income does not include salaries, portfolios, or investment income. Nonpassive activities are businesses in which the taxpayer works on a regular, continuous, and substantial basis.
The definition above makes a distinction between passive income and portfolio/investment income. This distinction is used to determine what types of tax deductions might be used if you experience losses from a passive investment.
One of the key differences between passive income, investment income, and earned income is you don’t pay FICA taxes (such as Social Security and Medicare) on passive income or investment income.