Imagine getting paid without lifting a finger or breaking some sweat. This situation is a dream to most people and very difficult to achieve without being fortunate enough to win the lottery, receive some inheritance or some other windfall. For the rest of us, it is up to hard work, saving hard and strategic investing to achieve this status. Passive income is the holy grail in the personal finance space and in this article I break down how valuable this type of income really is.
An elusive dream?
Although it appears an elusive dream to many, a reasonable stream of passive income can be realistically achieved by most people. Methods for doing this by investing in stock market index funds are detailed in my previous posts here and here. It is a challenging journey which feels like climbing a mountain. To get to the summit, the investor needs to raise sufficient funds by working hard at saving a large proportion of their income over a reasonable length of time. Keeping an eye on expenses is crucial too. Once a sufficient portfolio has been constructed, it will be able to deliver passive income without any further work needed.
Case study – Active income
To earn active income, a person must put in the work and time. It is not as simple as that; there are many other costly and time consuming factors to consider when looking at active income. For example, in terms of costs a typical office worker may need to pay for expenses such as commuting to work, lunch, clothing for work and early morning latte.
Additionally, active income payments are taxed at a rate dependent on your salary. The more you earn the more tax you pay. Time is the other factor to look at; an hour’s commute each way and an hour’s lunch will take up 3 hours a day of your time. An 8 hour work day ends up looking like 11 hours, while costs are incurred along the way – this makes the hourly pay rate look far less appealing if you do the math.
Passive income – a comparison
It is all about working hard now to reap the benefits later. It takes a lot of work upfront in-order to start earning passive income. There are several perceived ways to do this such as real estate, online selling and blogging. However, these methods are not fully passive and need some input, big or small, from time to time. Here and in the financial independence community we focus on investing in stocks, one of the few ways which are truly passive.
When you have a portfolio of investments every dollar in it is like a little worker tirelessly putting in the work for you. This industrious army of workers never calls in sick, complains or goes on strike. It literally is the definition of making money while you sleep! The key to building wealth is to keep on increasing on this base; more workers equal more production.
At a high level, portfolio growth comes from both generation of dividends and capital growth. Income from the portfolio can come in the form of dividends but the 4% rule can be applied to safely withdraw funds. The 4% rule stipulates that if this proportion is withdrawn annually, it is almost impossible to deplete the portfolio.
Passive income benefits
It is important to understand the difference between these two types of income to see how they can impact your finances and lifestyle. In comparison with active income, passive income is beneficial in that it frees you to earn additional income if required. If this additional work is voluntary, then you are able to choose the kind of work and how much of it to do.
Stress is reduced as there would be no ongoing pressure to keep on earning to pay the bills. A constant stream of income can also come in handy when emergency strikes or if you become unable to keep on working. Imagine getting fired or let go at an inconvenient time such as an economic downturn or when you have a family to support.
Being your own boss can become a reality too as you will be more capable and have time to start a business venture. You may also have more motivation to do your best work when not in a 9 to 5 environment. Depending on where you hold your investment funds it may be possible to not pay or pay very little tax on investment income. Location freedom is an additional benefit – without being tied to certain place of work you can choose where you want to be at any time. This could be on the beach, at home or in a cafe instead of a cubicle.
Generation of wealth would also happen faster as dividends can be reinvested to buy more units in future. All these cost related and intangible benefits make passive income at least twice as powerful as active income. This makes it appealing and well worth striving for.