Introduction to Passive Income

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One of the easier ways to gain financial independence is to reconfigure your life so that a substantial portion of your income is not actively earned by your labor. To accomplish that, you will need to earn passive income. Passive income is money received that requires little or no effort to maintain the flow of income once the initial work has been done. Some common examples of passive income include:

  • Pensions

Why Passive Income Is so Attractive

Passive income is attractive because it frees up your time so you can focus on the things you actually enjoy. If workers in most professions want to earn the same amount of money and enjoy the same lifestyle year after year, they must continue to work the same number of hours at the same pay rate—or more, to keep up with inflation. Once you decide to retire or find yourself unable to work any longer, your income will stop unless you have some form of passive income. In the past, this was easily accomplished with participation in company-sponsored pension plans, but those are far less common today.

The Two Broad Types of Passive Income

There are passive income sources that require capital to start, maintain, and grow—and there are those that do not. Which of the two you focus on throughout your career will likely depend on your current financial situation, talents, skills, and personality.

Ways to Earn Passive Income

Individuals who choose to focus on passive income that requires capital to start will need either family money, funds from investors, or the nerve to borrow large sums by taking on debt to fund the purchase of assets. Consider someone who takes out substantial bank loans to build an apartment building or buy rental houses. Although this can turn a very small amount of equity into a large cash flow stream, it also has risks. When using borrowed money, the margin of error is much smaller because you can’t absorb the same degree of setback before defaulting and finding your balance sheet obliterated.

Another example of passive income that requires capital to start is someone who has an ownership stake in an operating business such as a factory or furniture store and allows the business to issue debt to fund expansion. The early store managers in Wal-Mart who were allowed to invest before the company went public were in this position.

The second category of passive income is drawing on sources that do not require capital to start, maintain, and grow. These are far better choices for those who want to start out on their own and build a fortune from nothing. They include assets you can create, such as a book, song, patent, trademark, online site, or recurring commissions. The dominance of the Internet has made way for businesses that earn nearly infinite returns on equity, such as dropship e-commerce retailers that have little or no money tied up in operations but still turn a profit.

Many people have earned some passive income through online advertising from websites that require limited daily upkeep. These publishers are able to generate web traffic by producing content early, then letting search engines do most of the work of drawing people to the site.

The Most Common Path

Generally, the most common path to generating large passive income streams is to work at a primary job and use your actively earned income to buy assets that regularly generate passive income. For instance, someone could use their income to buy stocks, and over time, the nature of compounding, dollar cost averaging, and reinvesting dividends can result in a portfolio that generates substantial passive income. The downside is that it can take many years to achieve enough to truly improve your standard of living.

However, it is still the surest path to wealth.

Tax Benefits

A major advantage of earning passive income is that it is often taxed more favorably than active income. The reason is that it gives people an incentive to invest in assets that will help grow the economy and create jobs.

Money from dividends, for example, are taxed at a lower rate than money from a job. A business owner who works in the company they founded would have to pay more self-employment payroll taxes than someone who merely had a passive interest in the same limited liability company and would only pay income taxes. The same income earned actively would be taxed at a higher rate than if it were earned passively.