Passive Income

When people think about their financial future, they often picture retirement at 65 living off of their savings. However, many people wonder how they could afford an earlier retirement. The whole FIRE (financial independence, retire early) movement was based on this, but proponents of FIRA focused on reducing your expenses. Passive income can be a great way to retire earlier, but still maintain your standard of living by focusing on increasing your income.

What is it?

Passive income is money that you earn without having to do a considerable amount of work (material participation, as the IRS calls it). The two main sources of income that the IRS classifies as passive income are as follows:

• Renting assets: Property is one asset you can rent out to someone else to earn passive income. Real estate is valuable as it can provide a passive source of income and the asset can increase in value over time. Although considered passive income, rental properties can very easily turn into a 2^nd full-time job. If you’re looking for an income where minimal work is needed, you might want to look at other passive income sources. You can also rent out equipment (machinery, vehicles, e.g.), but unlike real estate, most equipment will depreciate over time.  To mitigate this, the government allows a tax deduction for the depreciation of your equipment.
• Owning/investing in a business: If you have enough capital, owning/investing in a business can be another source of passive income. For it to qualify as passive though, you must have no material participation in the business, meaning you can’t be managing or handling the affairs of the business. For example, if you owned a restaurant, hired a manager, and still were engaged in how the restaurant was run, it would count as active income. However, if you owned a restaurant, hired a manager, and the only thing you did for the business was receive a check, it would count as passive income.

Tips to Know:

• One of the main benefits of passive income is you get to write off your losses against your passive income. This means that if you had a property that lost $50,000 due to depreciation and expenses, but you earned $50,000 from another passive source, you would receive the $50,000 tax free. Note: Passive losses can only be written off up to the amount of your passive income that year. If you have losses greater than your income, then you can carry those losses forward to the next year.
• Investing in passive income also helps diversify your income. This can protect you from experiencing financial hardship if you experience a job loss or are unable to work.

Additional Sources of “Passive” Income

Although most people would consider these following sources of income passive income, they are not considered passive income by the IRS, which means you can’t write off your losses against your income. However, for someone considering their options to generate cash flow but can’t afford passive income through business ownership or a rental property, annuities, dividend stock, and bonds could be a good starting point:

• Annuities: Annuities are an insurance product that provide guaranteed income to protect you from outliving your money. You can pay for some annuities with a single lump-sum payment while you can pay for others over an “accumulation period”. Annuities tend to have a negative connotation due to high internal fees, but they can be a good fit for people looking for a low-risk, stable income that lasts for the rest of their life.
• Dividend stocks: Stocks that pay dividends can be another way to get your money to work for you. Dividends are paid from a company’s profits to stockholders, but they aren’t guaranteed. Buying stocks from a company that has regularly paid out dividends will increase the likelihood that you will also receive a dividend. When it comes to which type of stock to purchase, preferred stock has a set dividend rate, and preferred stockholders will be paid earnings before common stockholders.
• Bond Laddering: Bond laddering is an investment strategy where you buy several bonds with different maturity dates. This allows you to have the flexibility to mitigate interest rate risk as you can reinvest as your bonds mature. Because bonds are less risky than stocks, the return is smaller, but bond laddering can provide a low-risk, steady income through interest payments.

Key Takeaways

Accruing passive income can be a great way to achieve financial independence. Even if something is technically considered passive income, it’s important to think about how much work it will require and if it will bring additional stress into your life. Finding ways to supplement your normal income can help you achieve financial independence sooner.

If you have any questions on how to best prepare your family for the future, one of our advisers would be happy to help!