Passive Income: A Comprehensive Guide

Passive income allows you to earn money and build long-term wealth without actively working on a day-to-day basis. There are a variety of passive income opportunities, such as property rentals or stock investments, that can help you meet your financial goals.

Read on to learn what passive income is and how you can earn a living or just some extra money without active effort.

Table of contents

• What is passive income?
• How to make money from passive income
• Benefits of passive income
• Disadvantages of passive income
• Importance of risk management and diversification
• Taxes and passive income
• FAQs

What is passive income?

Passive income is money that you make without doing a lot of active work, such as making money from renting out an extra room in your home. Unlike active income, you can earn passive income from an action you completed once, like writing a book.

Passive income may be a great complement to a full-time job you already have. With enough passive income streams, you may be able to stop working altogether.

How to make money from passive income

Making money from passive income often requires setting up several types, or "streams," of passive income. By optimizing your opportunities to earn without actively working, you may be able to supplement or replace traditionally earned income. There are a variety of accessible types of passive income including rental property, dividends, capital gains, interest, royalties and business income.

Rental income

Rental property income comes from renting or leasing a piece of property you own for a profit. In some cases, you may not even need to own the property to rent it. Consider legal subletting, which allows you to rent your apartment to someone else for part of your lease term.

Leasing out an apartment is not the only way you can make passive rental property income. Sharing economy apps, such as Airbnb and Swimply, have made it possible to also rent the following types of properties:

• Your vacation home
• Your car
• Your garage or shed
• Your yard as a dog park
• Your swimming pool

Additionally, if you own property with desirable natural resources such as oil, mining or lumbering potential, you may be able to sell rights to this. Sometimes, cell phone companies may pay for access to high ground to host one of their towers.

All of these options allow you to leverage property you already own as sources of additional cash flow.

Dividend income

Strategic investments in dividend-paying stocks may lead to passive income. Dividend income comes from the rewards that some corporations pay to investors who own its shares.

You may earn dividends from a variety of stock market funds, such as mutual funds, index funds or exchange-traded funds (ETFs). Working with a financial advisor to purchase dividend stocks through a brokerage account can get you started investing in dividend stocks. Advisors can also help you strategize on spending and reinvesting income earned from dividends.

Capital gains income

When you sell something for more than you purchased it for, you realize capital gains. For instance, when you sell property that has appreciated in value, the profit you earn is capital gains. However, it may take a long time for an investment to mature to the point where you can sell it for profit.

Some examples of items you can sell to realize capital gains include:

• Property and real estate
• Stock market investments
• Cryptocurrency

Interest income

Another way of earning passive income is through interest on money you've invested or put into a savings account. While most types of bank accounts offer negligible interest, there are other types of accounts that may pay higher interest rates, including:

• High-yield savings accounts
• Certificates of deposit (CDs)
• Money markets
• Bonds
• Real estate investment trust (REITs)
• IRAs
• 401(k) or 403(b) retirement accounts

Interest payments are a type of income that can support passive income for a long period. Though it requires an upfront investment, earning sizable interest payments is a goal for many savers and investors.

Royalties income

Royalties are derived from intellectual property rights, such as books, music, patents, or trademarks. When you own these rights, you can receive payments in the form of royalties whenever this intellectual property is used or sold by others. Payments can come directly from product sales, streaming platforms and licensing agreements, to name a few.

Once the intellectual property is created and protected, royalties can continue to flow in over an extended period, contributing to a passive income stream and long-term wealth accumulation.

Business income

Though starting a business may require full-time work at the outset, a business may eventually turn into passive income. This often occurs when there is enough growth to hire other employees. These employees can take on the roles the founder previously exercised and continue running the business even after the founder retires or moves on to another project.

A founder who retains ownership of a business or a stake in a company's stock will continue to profit from the earnings of the business. Founders may design their businesses with the goal of creating a passive income stream in mind.

Other types of passive income

There are other types of passive income that can earn you extra cash. In recent years, social media and digital products have offered a new range of passive income opportunities. Below are some examples of sources of income for content creators:

• Creating podcasts
• Selling products or dropshipping on Amazon
• Starting a YouTube channel
• Designing or printing passive income t-shirts
• Becoming influencers
• Developing an online course in an area of expertise
• Utilizing affiliate marketing on blogs or social media accounts

Another option to consider is peer lending. Peer-to-peer lenders offer upfront investments to borrowers who are not pursuing traditional bank loans. They receive interest payments back from the borrowers and can make a profit. These partnerships of lending and borrowing may be very favorable to both parties but may be risky as there are fewer regulations in place than with traditional loans.

Benefits of passive income

Transitioning from active work to earning money passively may produce benefits such as more free time, flexibility and long-term wealth. We'll go through these benefits in detail below.

Earning money without actively working

Earning money without having to go to a typical job is a goal for many passive income pursuers. There are instances when working a full-time job may become difficult and passive income could be an important supplement. For example, passive income can be helpful after retirement, when you're recovering from an injury or illness, while raising children or while pursuing other opportunities like travel.

Generating income even when you're not present

With passive income, you can generate income while not having to be present at a certain work location. Passive income earners may be trying to free their schedules for passion projects, to spend time with family or make money from home. Passive income requires some upfront work and investment, but after that initial period, earners can continue generating income without being present.

Some of the types of passive income that you do not need to be present for include:

• Property rentals managed by a property manager
• Businesses left in the hands of a new manager or CEO
• Creative works distributed by a publisher or online marketplace

Building long-term wealth

For many, passive income streams are the building blocks for their long-term wealth. Rental properties, dividends from stocks, and royalties are diversified streams that can grow wealth, even if more than one is not performing as well.

Passive income allows you to generate income without actively trading your time for money, therefore providing financial freedom and the potential for exponential growth. If you continuously reinvest passive income, you can create a compounding effect that accelerates wealth accumulation over time.

Disadvantages of passive income

While passive income may seem like a great idea, it has its disadvantages. Protecting your financial health means anticipating these issues.

Disadvantages may include losing money due to diversification issues — relying on only one type of passive income may be risky and lead to significant losses if that income stream fails. It takes work to set up a passive income stream, but you may need to continue earning active income for financial security.

Passive income can also mean you have to deal with complex taxes. Different types of passive income may be taxed differently. For example, earned income and capital gains are taxed at different rates, and you must declare earnings on all interest-bearing bank accounts.

Importance of risk management and diversification

There is a level of uncertainty with all investments. To cope with this uncertainty, most experts emphasize a need for risk management and diversification.

In terms of managing passive income, this often means diversifying income streams. In other words, you shouldn't rely exclusively on any one particular source of passive income. Instead, invest in multiple types of assets and make sure you have more than one income stream in case one fails.

Taxes and passive incomes

All income is taxed, but passive income may be taxed differently. The Internal Revenue Service (IRS) has documents detailing each of these tax scenarios, but they may be complicated to understand. When you have multiple streams of passive income, it's best to coordinate with a tax professional to ensure you pay the correct taxes on each form of income. Some of the common passive income tax rates and rules are as follows:

• Dividends: Dividends that are qualified are taxed at a 0%, 15% or 20% rate based on income.

• Capital gains: Can be taxed at 0%, 15%, 20% or 28% depending on the property sold and your income.

• Interest: Interest from financial accounts like savings accounts must be reported with your taxes using Form 1099-INT.

• Royalties: Taxed as ordinary income and reported on form 1040.