Passive income is the Holy Grail of financial independence. Although modern Western society and capitalism relies on the Puritan work ethic, the idea that labor is a value to society and hard work is the path to a spiritual and successful life, most people would prefer not to trade their time and effort for an opportunity to survive financially.
There are good reasons. The work ethic is designed to benefit employers, not employees. Even though the labor movement worked hard to ensure humane conditions for employees, in the business world, the idea of spending countless hours at the office is rewarded in some working environments. Employees are made to feel guilty about desiring work/life balance, as excellence in an organization is a goal that requires a measure of imbalance. Unwavering dedication to the job above all other priorities is rewarded.
This approach might make sense if a job is also a passion, but for the vast majority of people, passions exist outside the office. Families, hobbies, and personal missions all have higher importance on the scale of values, but they often don’t have the ability to provide the financial incentive necessary to make life easier for families, hobbies, and personal missions. When eight or more hours of the day are lacking passion, the results are the tired memes of the ordinary workplace:
- Is it Friday yet?
- I can’t wait to get out of here.
- She’s retiring this year; she’s lucky.
- My coworkers are so annoying.
- The boss expects too much and then raises the bar when I exceed expectations.
- I can’t get anywhere in this job.
The list goes on.
It’s no wonder at all people view the idea of passive income as salvation. Rather than trading in effort and time for a paycheck, your assets generate income while you sit back and relax, spend time with your family, and pursue your less lucrative passions.
Passive income exists, at least from a tax standpoint. Income from a rental property or from a partnership where you aren’t actively involved is considered passive income. The IRS treats this type of passive income differently than other income, even if that income comes in the form of dividends from an investment portfolio, what some might also call “passive income.” The truth is that all income requires active involvement, but perhaps it’s a matter of degree.
The IRS considers income from real estate investments passive income, but managing real estate can be a full-time job. Don’t expect to sit back and your investments to thrive, even if you have a management company handling the day-to-day work. In fact, unless you’re able to amass a significant volume of real estate, or if you do most of the work yourself, it’s unlikely the time and effort you spend will be as profitable as you expect.
Expect the same disappointment if you’re looking to dividend income as your path to wealth. If you calculate that you would like to replace $50,000 of your toil-based income, you would need to have $1 million invested in investments paying a 5 percent dividend. (I’m ignoring the difference in income tax just to keep the example simple.) $1 million is a large bank balance, but it is achievable. You can’t, however, just put $1 million in an investment paying a 5 percent dividend and forget about it.
Any investment requires active involvement, starting from the beginning. You need to choose the right investments to start, and you need to monitor your investments over time. Sure, you’re not toiling in the field or wiping sweat off your brow at a construction site, but you are spending time researching your investments. You also need to pay attention to ensure your investments continue to perform. Companies decide to cancel their dividends without so much of a warning, so you should follow the company’s financials to be aware of any signs of trouble before the executives decide to reinvest profits, if any, rather than continue the distribution to shareholders.
When it comes to letting your money earn your income, nothing beats bonds. Suze Orman and financial planners offer advice to the general public, extolling the virtues of investing in a portfolio made almost entirely of stocks, but if you look at Suze’s own portfolio, which is designed not to increase value over time in exchange for risk but to generate income year after year, she invests primarily in bonds. (Her investment was in bonds as of a few years ago according to her own admission in a news story. I don’t know whether this is still the case, but it’s likely.)
Taking a step back, while Suze — and many other investors, but she is a good example — invests her portfolio for passive income, she’s not sitting back and relaxing with her life. While she may have money managers who handle her investments for her, she still trades her time and effort for an income.
Are you seeking the Holy Grail of passive income?
Published or updated May 23, 2012.