Forget about home ownership and from your own bootstraps success stories; my husband maintains that the American Dream is “earning more while working less.” And, in a way, he is right. Many people do believe that they have it made if they can earn money while doing practically nothing. And I guess you do. This type of income – income that comes even though you don’t really do anything – is known as passive income. And it can be a real help when it comes to improving your cash flow.
What is passive income?
Let’s look at a quick working definition. According to the IRS, passive income comes from “trade or business activities in which you do not materially participate.” This type of income comes from a sort of set it and forget it kind of place. You do not have to actively work to keep the money flowing, yet it still does, regular as clockwork. Some examples include:
- Property rental income.
- Business earnings from ventures that do not require your direct involvement.
- Royalties from patent licenses, intellectual property or book publishing.
- Residual income. (This is regular income that comes as a result of ongoing payments. For example, if you sell insurance, you might receive continued income every time your clients make their premium payments.)
- Earnings from online resources, such as advertising on your Web site, or affiliate and referral earnings.
For our purposes, we will also include returns you receive in interest and dividends from stocks and/or bonds. The IRS considers these to be what is called portfolio income, but these are passive in nature, and it does provide you with regular cash inflow without your ongoing involvement.
Is this cash flow really passive?
One of the more interesting questions with regard to this type cash flow is whether or not it is truly passive. From the standpoint that you might not be doing anything active to “earn” it right now, it could certainly be considered passive. But if you look at it from the perspective of the original attempts at earning it, you might discover that it is not all sitting around and doing nothing.
Indeed, most people had to do something quite active in order to set things up. If you are reaping the benefits now, it usually means that you put in some hard work up front. It takes some time and effort to set up a Web site that attracts enough traffic to generate the ad revenues you might have. Looking for good dividend investments for your income investing needs can be time consuming and requires a great deal of research and mental labor. You can’t collect royalties on a book unless you have first worked to write it.
Just about every form of passive income is preceded by some kind of active work. This means that in order to enjoy rewards later, you have to put in the effort now. But if you are smart about it, and careful, you can create earnings streams that will last you a life time, improving your cash flow and diversifying your earnings in such a way as to help protect you against the realities of job loss and recession.
Warnings You Should Heed
Passive income can truly provide you with a number of helpful advantages in terms of money. However, it is important to be careful, and to make sure that your actions are rooted in reality. Here are some things you should consider:
- Adjustments may be necessary. Especially in the case of dividend and income investing, it may be necessary to make adjustments. Business earnings and Internet earnings may require additional attention and tweaking. Just because your earning is supposed to be hands off, it doesn’t mean that you won’t ever have to touch the sources again. Especially during times of recession you may need to make changes in your spending, and adjust your earning streams and/or portfolio.
- Watch out for scams. Because of it’s popularity, and the idea of earning money from home is so desirable, scams are becoming prevalent. It is important to carefully screen all such “opportunities” that you may come across. Remember: If it sounds too good to be true, it probably is. Setting up such businesses usually requires more work than ordering a special kit to “automate” your earnings. You’ll need to do that on your own.
- Passive income can be lost. Just because you have it set up now, and it has been coming in regularly doesn’t mean that your earnings will remain at the same level. Dividends are cut. Books stop selling as well. Your Web site loses traffic. Keep in mind that you still need to make a plan for your money, and that you should not rely too heavily only on one or two income streams. Make sure your earnings are sufficiently diversified to absorb dramatic changes in your businesses.
- Don’t forget your estimated taxes. Since taxes on passive income are not withheld at source, as they are from your paycheck, make sure you figure out your quarterly tax payments to avoid penalties from the IRS or your government taxing authority. You should work with your tax professional to determine your quarterly tax payments.
In the end, passive income can be a great tool. But you have to use it carefully, or you might find yourself with dwindling returns and nothing to fall back on.