What Is Passive Income? It Could Be Your Key to Financial Freedom

Passive income streams provide you with a (mostly) hands-off way to grow your wealth and gain financial freedom. Here’s how it works, and some ideas for you to try.
Last updated Jul 9, 2020 | By Stephanie Colestock
What Is Passive Income? It Could Be Your Key to Financial Freedom

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Even as children, we grow up knowing that to earn money, we will one day need to get a job and go to work. The idea of active income is ingrained in us and we expect the effort it will one day require.

What’s unfortunate is that we aren’t raised learning much about passive income. But it’s these set-it-and-forget-it income streams that really have the potential to grow our wealth, and help us achieve our own level of financial freedom.

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What is passive income?

You spend your entire career working hard for a paycheck and put in the hours to generate income. But there are only so many hours in a day. Even if you wanted to work a dozen jobs, you would eventually run out of resources (i.e. your time and energy), and limit your ability to earn more money.

But what if you could further increase your income without a lot of work for every single dollar?

When it comes to building wealth and planning for the future, one important strategy is creating a revenue stream that is (mostly) hands-off. This is called passive income, and it has the potential to completely transform your personal finances.

The difference between passive vs. active income

I would imagine everyone reading this is at least somewhat familiar with active income. As teenagers, we babysit and mow lawns to earn spending money. As young adults and beyond, we work full-time jobs paying hourly rates, salaries, or commission in exchange for our efforts each week. We may even throw in a side hustle if we want to bring in a little extra cash each month.

Because these earnings depend on — and are directly correlated to — our continuous efforts, they are considered active income. If we were to stop going to work, stop making sales, or stop completing jobs, the income would also stop.

On the other hand, we can create income streams that allow us to earn money on a regular basis without any continuous, active effort. These are referred to as passive income. And these passive income streams can not only transform your cash flow today, but they can also help secure your future, even into retirement.

Here are some common active and passive income opportunities, so you can see the difference:

Active income Passive income
Earning extra money through ridesharing or meal/grocery delivery Lending funds through a peer-to-peer platform
Selling items online Investing in real estate
Turning your favorite woodworking hobby into a weekend side hustle Earning interest on your emergency fund through a high-yield savings account
Teaching fitness classes after work Creating an online PDF course or e-book
Working as an event photographer Selling stock photos online

Although some active income ideas take less effort than others — and some passive income ideas may still require occasional work — it’s easy to see that passive income provides you with a mostly hands-off revenue stream.

Examples of passive income

Here’s a look at some of the most popular (and lucrative) passive income streams, and how powerful they can be for you and your finances.

Dividend stocks

Whether you’re an investment pro or are intimidated by the idea of getting started in the stock market, dividend stocks should be on your passive income radar.

These stocks are often purchased through established and financially secure companies. When the company does well, its shareholders are rewarded with dividends, or regular cash payouts. Essentially, you’ll be paid just for holding the stock and supporting the company. In good times, these regular dividend payments can become a reliable source of passive income.

Bonds and bond index funds

Putting your money in bonds or bond index funds is one form of passive investing that’s worth a look.

Bond investments, though not entirely free of risk, are typically much safer and less volatile than traditional stocks. They provide investors with predictable growth in addition to regular payouts, usually twice a year.

High-yield savings accounts

Choosing where to put your savings is important if you want it to work for you and steadily grow over time. By putting your money in a high-yield savings account, you will both keep it safe and allow it to earn interest.

Although the interest earned from high yield savings won’t make you rich, it can earn you considerably more than if you left your savings sitting in a traditional checking or savings account, or tucked your emergency cash beneath the mattress. In fact, some online banks — like Cit Bank — offer far above the national average interest rate.

Rental properties

Investing in rental property has the potential to be one of the more time-consuming income streams, but also offers great opportunities for passive growth.

There are many options when it comes to real estate investing. You can:

  • Purchase residential property and self-manage or hire a property manager
  • Invest in commercial real estate, on your own or through a crowdfunding platform
  • Invest in industrial space

Each of these can provide you with monthly payments in the form of rental income. You will also build equity in your rental investment over time.

Learn insider secrets from the experts to help you get started with real estate investing.

Real estate investment trusts

A REIT, or real estate investment trust, is a vehicle that allows you to invest in a number of different properties at the same time, as a way of generating income. Examples of these are Crowdstreet and Diversyfund.

REITs act similarly to exchange traded funds in that your investment is spread across many different properties and even different sectors. These properties are managed by someone else so you don’t have to worry about the ins and outs of that. However, you will enjoy steady dividends on your investment.

Peer-to-peer lending

Banks lend money to borrowers as a way of generating passive revenue by charging interest. So why shouldn’t you be able to do the same?

Peer-to-peer (P2P) lending platforms allow everyday people, like you, to loan money to borrowers across the country who are seeking funding for a variety of purposes. These platforms let you choose which borrowers you’d like to fund, as each comes with their own risk levels and accompanying returns.

As a P2P investor, you’ll enjoy passive income through the interest earned on your loan. Plus, you can often get started with as little as $1,000 through platforms like Lending Club.

Sell your knowledge

One great way to create long-term passive income is to sell your creativity, knowledge, or skills. You can do this by writing a book (or e-book), creating an online course, or developing a downloadable purchase (such as a template for someone starting a blog).

The investment for this is primarily your time in creating the product and setting it up on the sales platform of your choosing. Once that’s done, the active effort required is usually minimal, while your products can continue to generate hands-off, passive income for years to come.

How to begin earning passive income

Once you recognize the power of passive income and the impact it can have on your finances, you’ll probably want to know how (and how quickly) you can begin earning it.

You’ll want to first take a look at where you stand financially, so you can decide where exactly to start. This means determining a few things.

1. Decide how much money you have to work with

Do you only have a few hundred dollars to put away? Or a significant nest egg? Or have you recently come into a massive windfall of money you want to optimize?

The amount you have available to save or invest can dictate where you first focus your efforts. For example, if you have $100 to start with, a high-yield savings account with no minimum balance may be the easiest place to put it. Many bank accounts have a $0 minimum deposit amount and still allow your money to grow safely.

If you have $10,000 to invest, however, you may want to consider whether crowdfunding (real estate or P2P lending) could provide you with better passive income returns.

2. Consider how accessible you need your funds to be

The way you approach your passive income strategy depends largely on whether your investable funds are already earmarked. You might want to find a way to earn on your emergency fund, for instance, but that money must remain accessible in case something happens. In this case, a no-penalty CD or high-yield savings account might be the right answer.

However, if you already have adequate, liquid savings you may want to set your sights on another passive income venture, such as bond index funds or REITs.

3. Consider if you have the time for some effort

Owning rental property can be very lucrative, but it does involve a fair amount of effort over time. Whether you self-manage your renters or pay a management company to do so, you’ll need to be available for questions and to foot the bill for large repairs. It’s important to decide whether you’re willing to take that on.

Conversely, some passive income streams — such as online courses and e-books — take a set-it-and-forget-it approach. You put in the effort upfront and then, for the most part, sit back as the income rolls in.

Being a blogger and making money off Google ads or affiliate marketing might fall somewhere in between. It’s important to decide where you fall in that willingness-of-effort spectrum.

4. Ask yourself what you have to offer that others will pay for

If you want to create a recurring product or service that others will spend their hard-earned money on, you need to first determine what you have to offer. Think about your acquired knowledge, experiences, and skills. Can you compile and present any of that in a way that buyers would find helpful? If so, you may have found your answer.

This category of passive income includes things like:

  • Online courses
  • E-books
  • Digital products (templates, photography presets, etc.)
  • Printables (worksheets, planners, etc.)

You’ll need to put in the initial investment of time and money to get the product ready for launch, and it may need occasional updating and/or marketing. For the most part, though, this is a very passive source of income.

5. Think about your passive income’s purpose

In strategizing your passive income efforts, it’s important to spend some time thinking about the why.

Are you interested in developing passive income streams as a way of reaching your financial freedom goals? Do you want to make an extra $1,000 each month or are you hoping to retire early on passive income alone? Do your financial goals have a timeline?

How you answer these questions may guide your path forward. If you’re hoping to retire by 35 on just your passive revenue, you’ll probably need to take a much more aggressive approach. If your goal is to create steady growth to build funds for a more traditional retirement, you may choose to focus your efforts in different places. And if you simply want your money to safely grow while it’s not being used, there are options for you too.

A few things to know about passive income and taxes

When you hear the phrase taxable income, you probably first think of your paycheck. However, the Internal Revenue Service (IRS) won’t forget about your alternative income streams just because you aren’t actively working to earn them each month.

How your passive income is taxed depends on where and how it’s earned. Some may be considered ordinary taxable income, such as the sales from an online e-course or interest payments received from a peer-to-peer loan. This means it will factor into your adjusted gross income (AGI) and taxes will be calculated based on the income bracket in which you fall.

On the other hand, taxes may be calculated differently for money earned in a savings account, on dividends received throughout the year, or in the form of capital gains. In some cases, you may be required to make estimated tax payments throughout the year for the taxable interest you’re receiving.

Depending on where you live and what you invest in, you may be exempt from certain state and/or federal taxes on your passive income. Certain categories of income are taxed at lower rates than ordinary earned income, as well.

The safest approach is to consult with a financial advisor or tax professional if you want to learn more. That way, you can make informed decisions about your tax planning and future investments, as well as ensure you are paying taxes correctly for both your active and passive income streams.

Bottom line

From the time we are children, we begin learning about active income and the financial role it plays in our lives. However, it’s passive income that really has the potential to truly pay off and completely transform our finances.

Passive income can come in many forms. But whether you choose to invest in dividend bonds, create a product that others will buy for years to come, or simply want your savings to safely grow interest each year, creating the right passive revenue streams can help you build wealth for life.

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