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Passive Income: What it is & How to Use it to Build Wealth Thumbnail

Passive Income: What it is & How to Use it to Build Wealth

The idea behind passive income is to generate income without requiring significant day to day involvement on the part of the investor. Passive income allows for an accumulation of wealth without a person’s direct involvement once the initial investment has been funded.

Rental properties, financial portfolios of stocks and bonds, and private business investments are capable of generating regular cash flow. Each build wealth using various tools from interest payments, dividends, or limited partner shares. The Internal Revenue Service (IRS) also comes into play with guidelines that defines passive income for tax purposes.

As a financial planner, I like to see my clients first establish a solid foundation of retirement savings, contingency savings, and other goals prior to seeking passive income investments to supplement income. Once that foundation and savings habit is in place, passive income investments can be considered to supplement the financial picture. Different investments come with inherently different investment risks. Before you dive into passive income investing, talk with a financial planner prior to taking on these riskier investments.

3 Common Types of Passive Income

1. Rental Properties

Real estate is a popular investment for passive income and has substantial tax deductions to offset the tax liabilities. Renting out single residential dwellings, townhouses, condominiums, or apartment buildings is great for generating steady income.

Most investors hire property managers or landlords to maintain the property. Their job is to keep the property in good condition, keep units occupied, manage rental agreements, and address tenant issues. Tax benefits allow the owner/investor to deduct the cost of these services as well as mortgage loan interest, property taxes, and other expenses against the revenue collected without having to participate in the daily operations.

The downside of purchasing a rental property is that you are typically investing in a single property initially, and, as the saying goes, putting all your eggs in one basket. Make sure your expected return on investment (ROI) after all expenses are included is worth the extra risk you are taking. Real estate investment trusts (REITs) are another option and provide an easy way to invest in a diversified real estate portfolio. Whichever approach you decide to take, consider working with a financial planner who can work through the numbers with you to determine if the investment is worth the risk and fits well into your overall investment portfolio.

2. Private Business

Consider investing in a business by providing capital. Become a limited partner while the developer or entrepreneur works on generating passive income for you. The relationship as an investor and limited partner is linked to the amount of funding and the percentage of earnings. There should be a written contract with the terms and conditions. Depending on the structure of the company, your investment could pay dividends on a regular basis.

Similar to purchasing a single property for passive rental income, investing in a private business has its own set of risks too. Private businesses tend to be smaller companies and as such have a higher market risk that the firm will not return the expected profit. These companies may be dependent on a few individuals who could potentially leave the company. Private businesses also have less liquidity in the event you need your initial investment back along with a typically a higher risk of default.

3. Investment Portfolios

Financial portfolios offer a variety of passive income ventures. Stocks and bonds have proven to be good sources of passive income over time.

The basic concept of stock investing is to earn more money than you invested. If a stock you purchased increases in value, you can sell it for a profit. If the stock decreases in value and you sell it, you lose money. Stock values can go up or down daily, depending on a number of factors, all of which are out of the investor's control. Monitoring these factors can be a full time job, and knowing when to buy or sell is most often a guessing game.

History has shown that over the long term, stock prices tend to rise. Investing with a long term focus (typically 10 or more years) and with a diversified basket of stocks will have less risk than investing in a few selected individual stocks.

Investing in bonds is a form of lending money in exchange for scheduled interest payments. Bonds mature over time, and the issuer must repay the principal investment at maturity. There are many different types of bonds, including government bonds and corporate bonds. Bonds have different terms and varying levels of risk. Default risk for individual bonds is greater than the default risk of a bond fund, however most bond funds have interest rate risk, meaning their underlying value will change if interest rates go up or down.

Although passive income may not involve daily management or business involvement, it does require some research and analysis about the respective market and the associated investment risks. If you are considering opportunities for generating passive income, consider working with a financial planner. A financial planner can help evaluate the investment risks and expected return to see if the potential payoff is worthy of your investment dollars and if the investment fits into your financial plan and into your investment portfolio.

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This content is developed from sources believed to be providing accurate information.  Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.