Introduction to Passive Income

How to Make Money By Creating Passive Income

A hand holding a ten dollar bill above a pocket
••• Passive income refers to income that is generated from investments, often in the form of dividends, interest, or rents, rather than income that requires you to sell your time, skill, and/or labor. Image Credit: runner of art / Getty Images

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, it must come from passive income. The idea of passive income is closely related to the Berkshire Hathaway model.

The basic idea of passive income is that it is money received that requires little or no effort in order to maintain the flow of income once the initial work has been done. Some common examples of passive income are:

  • 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. A highly successful doctor, lawyer, or publicist, for instance, cannot “inventory” their profits. If they 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. Although such a career can provide a very comfortable lifestyle, it requires far too much sacrifice unless you truly enjoy the daily grind of your chosen profession.

Additionally, once you decide to retire, or find yourself unable to work any longer, your income will cease to exist unless you have some form of passive income. In the past, this was accomplished by employee participation in company-sponsored pension plans, but the economic upheaval of the 21st century changed all that, forever.

The Two Broad Types of Passive Income

There are two types of passive income. Throughout your career, which of the two you focus on will likely depend upon your current financial situation, talents, skills, and personality. The two categories of passive income are:

  • Passive income sources that require capital to start, maintain, and grow
  • Passive income sources that do not require capital to start, maintain, and grow.

Ways to Earn Passive Income

Those who choose to focus on passive income 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. The easiest to understand is 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 is not without risk. When using borrowed money, the margin of safety is much smaller because you can’t absorb the same degree of setback before defaulting and finding your balance sheet obliterated.

Another example of the first category of passive income 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, Internet site, recurring commissions, or businesses that earn nearly infinite returns on equity such as a drop-ship e-commerce retailer that has little or no money tied up in operations but still turns a profit.

The Path Most Often Taken to Passive Income

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 generate passive income on a regular basis.

The doctor or lawyer, for instance, could use her or his income to invest in a medical start-up or buy shares of medical companies he understands such as Johnson & Johnson. Over time, the nature of compounding, dollar cost averaging, and reinvesting dividends can result in her or his portfolio generating substantial passive income. The downside is that it can take decades to achieve enough to truly improve your standard of living. However, it is still the surest path to wealth based on the historical performance of business ownership and stocks.

Taxes and Passive Income

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

For instance, a business owner who works in the company she or he founded would have to pay an extra 15.3 percent in self-employment payroll taxes compared to someone who merely had a passive interest in the same limited liability company who would pay only income taxes. In other words, the same income earned actively would be taxed at a higher rate than if it were earned passively.