Passive Income

What Is Passive Income?

Passive income is a source of earning that does not require active work or involvement to generate. Examples of passive income include dividends and interests from stocks and bonds, rental property income, royalties from patents, copyrights, and income from digital content.

According to the United States Census Bureau, 20% of American families earn around $4,200 in passive income via dividends, interest, or rental assets per year.

Passive income may be a significant contribution to wealth building. However, higher-income households are more likely to be able to invest in assets that produce these income streams.

What Passive Income Is Not

It is not passive income when the activity is an ongoing, active business pursuit that requires material participation. 

The Internal Revenue Service (IRS) classifies an economic activity as material participation if an individual has worked on it for more than 500 hours in one year. Alternatively, it is also considered material participation if an individual has worked more than 100 hours on a shared project and no one else has put in longer hours than the individual. 

Activities that meet the qualifications for material participation are not counted as passive income. These include wages, salaries, tips and commissions. Instead, these types of earnings are usually received in exchange for active service.

How to Make Passive Income

Passive income may initially require a significant amount of labor. This is why some people devote time to active income generation first before establishing passive income streams. However, once a system is established, earnings from passive income may continue to grow.

In setting up passive income, it is essential to create something of value, something that people will want to buy again and again. This can be physical products, like books, or digital products, like apps. It can also be a service, like online courses. 

A strategy to get people to keep buying it should also be established. Finally, it is important to have upkeep to ensure that the product or service continues to meet customers’ needs.

After the passive income stream is set into motion, income will start to pour in without much active involvement.

Examples of Passive Income

Both individuals and corporations may find ways to earn passive income.

For Individuals

Individuals can earn passive income through a variety of methods, including:

Dividend Stocks

A dividend is a share of the profits that a company has made. A passive income stream can be generated by reinvesting the dividends back into the company to have a continuous flow of money.

Rental Property

This may be considered a passive activity, as there is often not much involvement after the initial investment. Often, rental owners only get involved in maintenance tasks and when it is necessary to collect the rent each period. Individuals can rent out properties, such as apartments, condominiums, or houses, to earn rental income.

Creating Digital Content

Someone who has expertise and passion in a particular subject can create digital content, such as an online course and earn income from it. This is an excellent way to share knowledge and build a passive income at the same time.

For Businesses

Aside from engaging in operating activities, corporations can also earn passive income in various ways, such as:

Royalty Payments

Corporations can earn royalties by licensing their intellectual property, such as patents or copyrighted material, and selling it to others. The user pays the owner a set fee each time they use the invention or work. 

Franchising to Other Businesses 

A business model where a company licenses its trademark, trade name, or operating system to an independently owned and operated business. This is a form of passive income as the company does not have to actively promote or sell the franchise.

Interest on Loans

Companies can loan money to other businesses or individuals and earn interest on the loan. The interest income that comes when the borrower pays the lender money qualifies as passive income.

Importance of Passive Income

Passive income is essential since it can provide financial stability, especially in cases where an individual’s capacity to earn active income is diminished.

Furthermore, because passive income is not restricted by time and effort, it has greater potential to accumulate wealth. 

Other potential benefits of passive income are:

Improves Cash Flow

Passive income can help to improve cash flow since it can be an additional source of revenue. 

An additional cash flow stream can help cover regular expenses and improve lifestyle. It can also be used for additional savings or investments.

Provides for Early Retirement

Passive income can help provide the funds needed for earlier retirement. The sooner financial goals are met, the sooner one can retire and enjoy life outside of the workforce. Whether it’s creating a business that runs on its own, investing in the stock market, or a mix of a few various income streams, passive income gives more opportunity to retire early.

Reduces Financial Stress

If bills are always piling up and there’s never enough money to cover them, financial stress can take a toll on health. Having a passive income can help to reduce this stress by providing another source of income that can be used to pay bills or save for unexpected expenses.

Challenges of Having Passive Income

It is important to understand the challenges that may be involved with creating and maintaining passive income. 

Requires Time and Effort

Creating a passive income stream often requires a significant amount of time and effort upfront. This can be especially challenging if someone is already working full-time or have other commitments.

Requires Upkeep

After creating a passive income stream, it is important to remember that it will require some form of upkeep. This might include regularly creating new content or maintaining rental properties.

Needs Some Capital

To get started with some passive income ideas, a certain amount of capital may be needed to invest. This could include money for buying rental properties or stocks. 

Tips for Making Passive Income Successful

Here are some recommendations to make passive income more successful:

Start Small

Some passive income streams will require more time and effort to get started than others. It can be helpful to start small and gradually build up to bigger projects.

Diversify Your Income Streams

Diversifying sources of income can help to reduce risk and increase stability. This could include investing in a mix of stocks, rental properties, and other options.

Think Long-Term

Many passive income ideas require a long-term commitment in order to be successful. This could include things like starting a blog or investing in rental properties. It is essential to take time before choosing an idea. 

Automate and Outsource Where Possible

There are many ways to automate and outsource tasks associated with passive income ideas. This can help to save time and make the process more efficient.

Be Prepared for Ups and Downs

Like with any other type of income, there may be ups and downs with passive income. It’s beneficial to have a cushion of savings to cover lean times.

Keep an Eye on Your Expenses

It’s also important to keep an eye on expenses when relying on passive income. This could include things like monitoring stock portfolios or keeping track of rental property expenses. Failing to do this could result in losses that offset the passive income earned.

Have Patience

Patience is important when creating passive income. It can take time to research and plan before starting a project. Additionally, some ideas may not produce results immediately and could take months or years to generate income.

Passive Income vs Active Income

Passive income is money obtained through a previous investment or job that continues to create money without any extra effort. In contrast, active income is money obtained in exchange for completing a service. 

There can be no designated and fixed work schedule in a passive income stream, whereas with active income, a defined work schedule may need to be followed.

Passive income often comes with higher risks and higher rewards. However, this also means that money streams may come in irregularly.

Conversely, active income usually has lower risk and lower rewards. Nevertheless, it can provide a more regular and steady flow of income than passive income.

Below is a table that highlights the differences between passive income and active income.

Passive_Income_vs._Active_Income

Final Thoughts

One of the crucial aspects of a reliable financial situation is passive income. Generating passive income can be done in many different ways, such as investing in dividends, renting out properties, creating digital content, and earning royalties. 

Passive income has the potential to provide a supplemental income, more free time and financial stability. 

It is important to remember, however, that there are also some challenges associated with it. These include the need for time and effort to get started and the possibility that it may not be as lucrative as active income.

There are many things to consider when choosing a passive income idea. These include the amount of time and effort required, the potential return on investment, and the risks involved. 

By carefully evaluating the factors that can affect passive income, individuals can choose an idea that is best suited to them.

Passive income can surely be a great way to generate additional income. With correct planning and execution, it can be a great addition to your overall financial strategy.

FAQs

The easiest passive income to start depends on the skills, resources, and time availability of the individual involved. However, some ideas may be easier to get started with than others. For example, investing in a hands-off index fund or starting a blog could be less complicated than buying rental properties.
There are several opportunities to earn money from home. This could include things like starting a blog, investing in stocks, or renting out a room in your house. There are multiple options available, so it's important to choose something that is a good fit for your skills and interests.
Passive income is income that is generated without the need for active work. This could include things like dividends from stocks, rental income, or interest from savings accounts. Active income, on the other hand, is earned through activities such as a job or running a business.
In most cases, yes. Passive income is generally subject to income tax. However, there may be some exceptions depending on the local laws and regulations.
Passive income may include dividends from stocks, rental income, interest from savings accounts, and royalties from writing a book.

Passive Income Subtopics

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.