Key Takeaways
- Generating adequate income is a challenge for many Americans. Unfortunately, most people do not have the time to work more hours to earn extra money. Passive income streams are a way to overcome this limitation.
- Passive income is income generated from an activity that requires little to no effort to maintain.
- Passive income differs from active income, which is earned by performing a time-consuming endeavor, such as working a job, maintaining a side gig or running a business.
- The tax implications of passive income are complicated. A tax professional can help make sense of things.
- There are different options for passive income sources, depending on your level of experience and available investments.
What Is Passive Income?
Passive income is generally characterized as income generated from an activity that requires minimal effort to maintain. This differs from active income, which is earned as a result of performing a time-consuming endeavor, such as working a full- or part-time job, maintaining a side gig or running a small business.
Examples of passive income include the interest and dividends paid by investments, the rental income generated from lease arrangements, the royalties acquired from intellectual property sales and the commissions earned through affiliate marketing programs.
Incidentally, the Internal Revenue Service does not consider all the examples above to be passive income. For instance, the IRS views interest and dividends earned as portfolio income, a classification that results in distinct tax treatment.
According to the IRS, passive income comes either from a rental property (other than real estate) or a business that does not require active participation. For more guidance, refer to Publication 925 to determine whether an activity qualifies as passive in the eyes of the IRS.
The IRS commonly refers to passive income and active income as unearned income and earned income, respectively.
What Are the Benefits of Passive Income Streams?
For people who are working hard, but slowly accumulating wealth, the opportunity to generate income without breaking their backs and sacrificing limited time with loved ones is incredibly compelling. Doing so may take a little creativity, but cultivating passive income streams can bolster the strength of your personal finances, increase your short-term flexibility and enable a higher quality of life in retirement.
Overcoming Financial Shocks
Financial shocks are a fact of life, and they can be crippling. Extreme examples include losing your job, being unemployed for an extended period, undergoing a costly divorce, dealing with a life-threatening illness or suffering a large, uninsured financial loss. A passive income stream can reduce the effects of financial shocks — especially for people in retirement who rely on a fixed income.
Increasing Financial Flexibility
Passive income arrangements give you enhanced flexibility and liquidity. Establishing a source of passive income might take some upfront work, but once you lay the groundwork, the amount of effort required to sustain the income stream is minimal.
An ongoing stream of cash can greatly enhance your liquidity position and give you more financial flexibility. Perhaps, you use the extra cash to pay down debts. Or maybe it can fund a much-needed family vacation. Future-focused savers could use it to boost their retirement savings.
Relieving Stress
Balancing the professional and personal aspects of your life can be very difficult and stress-inducing. For some, stress is amplified when you feel like you need to make more money to be comfortable.
There is only so much time in the day and not everyone can aggressively climb the corporate ladder or work multiple jobs. Passive income can lessen the need to pursue stressful arrangements, allowing you to better manage near-term financial obligations and save for retirement – without sacrificing your mental and physical health.
Tax Implications of Passive Income
Usually, passive income is taxed at the same progressive tax rates as active income. However, passive income generated from certain types of activities may be taxed at different rates.
That said, investment-related passive income can be sheltered from taxation, as long as the income-generating assets are housed within a tax-advantaged account – such as an individual retirement account (IRA).
With a traditional IRA, you get tax deductions for contributions you make and taxes are deferred until you begin withdraws in retirement. With a Roth IRA, you do not get tax deductions for contributions you make, but you benefit from the tax-free growth of your money.
Another notable tax implication associated with passive income is how losses can be used to reduce your tax obligation. Essentially, when you record a loss relating to a passive activity, it can only be used to offset the profit associated with another passive activity — but not any active income earned. Unapplied losses can even be carried forward to future tax years.
For in-depth guidance on the nuances of the Internal Revenue Code, consult with a tax professional.
Passive Income Ideas for Beginners
You’ve decided you want to generate passive income – now where do you start? Begin by taking inventory of things like your extra cash flow, your financial habits and unused asset. If you operate a website, evaluate partnership potential.
Based on your self-assessment, different options for generating passive income may be right for you.
Take Advantage of Competitive Interest Rates
Put excess funds in a high-yield savings account or certificate of deposit (CD). This is a low-risk way to pick up a solid chunk of income each month without lifting a finger. Today, the most competitive high-yield savings accounts are paying an annual interest rate just north of 5%. The most competitive CD rates fall between 5% and 5.5%, a slight premium to savings accounts, given their inherently lower degree of liquidity.
Use a Cash-Back Credit Card
If you have sound financial discipline, get a cash-back credit card and use it for everyday purchases. Use it for as many transactions as you can and pocket the cash-back rewards. Just make sure to pay your balance off in full each month. Incidentally, the IRS views cash-back rewards as a coupon/rebate. As a result, there are no tax implications.
Rent Out Unused Assets
Leasing arrangements are a great way to get full utility out of assets you do not need or rarely use. You can rent out unused assets such as a storage unit, a parking spot or an extra room in your home. Moreover, with an array of online marketplaces and forums, finding interested renters is easier than ever.
Start an Affiliate Marketing Program
If you have a website or blog, you may be able to establish a few lucrative partnerships, whereby you drive consumers to other websites. However, this would only qualify as a passive activity if you already have a high-traffic website that does not require ongoing content creation to drive traffic. Otherwise, it would push you into labor-intensive, active income.
Passive Income Ideas for Advanced Earners
People who are looking to supplement their already sizable income with passive income streams have several investment options, including ETFs, REITs and annuities.
Your unique goals and financial situation will determine which financial vehicle makes sense for you.
Invest in a Domestic, Investment-Grade Bond Fund
Purchase either a low-cost index fund or an exchange-traded fund (ETF). Make sure any fund you invest in is highly diversified, ideally, across all sectors, including Treasuries, municipals, corporates and structured bonds. Additionally, consider investing in a fund with a short to intermediate-duration, given the current interest rate environment.
Invest in a Dividend-Paying Stock Fund
Purchase either a low-cost index fund or an ETF. Make sure any fund you invest in is highly diversified — ideally with global exposure to large, defensively positioned companies.
Invest in a Real Estate Investment Trust (REIT)
A real estate investment trust is a fund-style investment vehicle that owns and manages real estate properties. Make sure any REIT you invest in is highly diversified and contains a competitive fee structure. Additionally, make sure the REIT management team has an extensive track record across different market environments.
Purchase an Annuity
An annuity is a financial contract with an insurance company, whereby you make a lump-sum payment in exchange for a series of income distributions for a specified period. These are low-risk arrangements, but make sure to focus on lower-cost products issued by highly reputable insurers.
Frequently Asked Questions About Passive Income
Passive income is usually taxable at the same progressive tax rates used for active income. That said, investment-related passive income can be sheltered from taxation if the income-generating assets are housed within a tax-advantaged account, such as an IRA.
In most cases, investment income can be categorized as passive income. However, for some high-frequency traders, it is more aptly categorized as active income. Incidentally, the IRS classifies passively generated interest and dividends as portfolio income, a classification that results in distinct tax treatment.
For most people, passive income cannot replace the salaries and wages generated from their jobs. However, if you have accumulated substantial wealth, the passive income generated by an investment portfolio could replace your salaries and wages.
In many cases, creating passive income entails investing in an income-generating asset, such as a high-yield savings account, a bond fund, a dividend-paying stock fund or a storage unit. However, not all passive income arrangements require cash outlays. For example, you can implement an affiliate market program without spending any money. You could also rent out valuable tools and equipment that you already own when you aren’t using them.
Editor Malori Malone contributed to this article.
