How To Earn Passive Income

These days it seems that everyone is looking for set it and forget it ways to make income. The problem is that you either need 1) valuable information that is static or 2) a grip of cash. Every other income stream in the world is not static in the least bit. If you have to constantly update the item (this blog is a great example) then it is no longer passive as it requires time.

Our definition of passive income is this:

“Income that is generated without the use of your time”

Other forms of income are at best… location independent income.

 

Passive Business

This is the type of business everyone dreams of. A set it and forget it business that generates loads of money without being monitored.

1) Static Website: In the older days of online sales (before they created video sales pitches and continuity programs), there would be a simple sales page followed by a product offering… You have seen these before.

“Do YOU want the WOMAN of your DREAMS?”

Followed by a lot of emergency type language (red text of course) and a “Click to Buy” and check out at the bottom.

These are always accompanied by testimonials as well. The consumer reads the entire sales pitch (usually a good 5-10 pages long) and then makes his purchase decision. This is 100% passive as you have a product that is simply sitting there with a sales pitch. If there is no need to update the product, then it is simply passive income.

2) Recurring Service: The second form of primarily static information would be a service. For those that work on Wall Street… a great example would be FactSet or Capital IQ.

Before you jump in and say “but these products are updated!” the point is that the revenue is recurring. If we really want to get nitty gritty then we can simply use software as an example. You pay for the use of a specific program such as Microsoft and then you bill the client on a yearly basis for 1) services (not passive) and 2) use of the software (passive) since the software would never be updated.

Naturally, the software is updated to keep up with competition, but you should get the idea. It is simply access to a value additive system that does not need to be updated in a meaningful way.

3) Location Independent Income: While this is not passive income, we will add it for clarification. Location independent income can be summarized as follows – “A task you can do on the internet”. That is all a person really means by “location independent income”. Since you are making your money through the internet as a medium of communication this can include 1) online company, 2) blogging and 3) convincing your employer to allow remote access.

Overall, we believe everyone should at least attempt to create location independent income. Ideally, you can create a massive income from a static website, but the vast majority will end up creating some location independent income. If you are able to create large static income, we commend you and you have accomplished a difficult task.

 

Passive Investments

This is the second form of passive income. Having a grip of cash. In finance, when you interview you’re asked for the most important financial statement. Generally speaking the best answer is “Cash Flow Statement” because… Cash is King. Managing cash flows is extremely important and a large sum of cash can help breed… More cash. With the importance of a high savings number let’s take a look at multiple investment streams from a risk tolerance perspective. We will start with the highest risk, highest capital growth and work down to lowest risk lowest capital growth.

1) Qualified Dividends: This is the most common source of dividend income. Simply put, if you own the S&P 500 you pick up a ~2% dividend (as of this posting) on an annual basis. This means that if you own $100K of S&P 500, you will also receive $2,000 by the end of the year. For most individuals the $2,000 will be taxed at 15%, however if you have a personal income of ~$400K or ~$450K as a household, then you will be taxed at 20%. We are not going to go into a long winded post discussing taxes and their merits; instead this is simply how the system works.

The Rub: Post tax yield of low single digits (2-4%) with more hope of equity upside. The higher the dividend the less expected equity upside on the stock (generally).

2) Unqualified Dividends (REITS, MLPS and Special One Time Dividends): What is the difference between a qualified and an unqualified dividend? The unqualified dividend is taxed as regular income. That is the simple difference. Today, REITs pay a high dividend, however you should be cognizant that the income you receive may be taxed up to 35% and beyond if you are in a higher income tax bracket

The Rub: Post tax yield of mid single digits (4-7%) with a bit less hope for equity upside.

3) Junk Bonds: We won’t go through a long winded explanation of how bonds are safer than equity. However. The simple explanation is that you’re first in-line in case of bankruptcy and you’re entitled to income “above the line” of the income statement (ie you represent the interest payment line.  Junk bonds pay high yields however… This comes with additional risk… Tread carefully when seeing high single digit yields.

The Rub: Strong yield of mid single (5-7%) with very minimal hope for upside, unless the Company sees large changes to is investment grade (in which they will likely buy back the bonds and reissue new ones at a lower rate).

4) Investment Grade Bonds: These are significantly less risky (unless you owned some of those collateralized debt obligations back in 2008) but essentially you’ll pick up a nice yield of ~3-5% and you can sit back, relax and collect those monthly coupons. Of course these bonds still have risk, but the debt ratings for these securities are quite tight.

The Rub: Medium Yield at 4% and we are approaching minimal risk territory.

5) Government Bonds: There are many types of bonds, 30 year bonds, 10 year bonds, 5 year bonds, 1 year bonds… we could go on and on. In addition to these durations, you also have different tax structures with municipal bonds, treasuries, treasury inflation protected securities (TIPS) etc. We could do a 70 page post on bonds and it still wouldn’t cover everything. Instead think of these bonds as “risk free”. Please note we are putting risk free in quotes because literally nothing in life is 100% risk free. If the government defaults, you will not get paid. However. We find this highly unlikely as we are not part of the doom and gloom, losing in life camp.

The Rub: Practically risk free and will likely outpace inflation by just a hair (excluding TIPS of course)

6) Certificate of Deposits: These are FDIC backed time deposit investments. They are essentially risk free and offer low rates. This is a poor tool for wealth creation, however a staggered long-term CD will allow you to keep pace with inflation (hopefully).

The Rub: Essentially a way to hedge inflation.

 

Securitizing Your Future

The big difference. How do you balance risk (higher risk at the stock level) and time (your age) to achieve the best balance for the future? In our view, the best balance is actually a bit less dependent on age and is more dependent on your life style and net savings.

Guideline according to us:

1)      If you have less than 5x your annual spending in savings. You should have it primarily in stocks. Call it 90% stocks and 10% cash in case there is an emergency

2)      As soon as you reach 5-8x in annual spending in savings you can make a shift. Here we recommend 70% exposure to stocks, 20% exposure to bonds and still a 10% cash position.

3)      As soon as you reach 10-15x of annual spending in savings, you are now near “retirement” in terms of ability to live entirely off of cash flow. Here you can have a mix with 40% stocks, 30% bonds, 20% low risk government bonds and CDs, 10% cash.

4)      As soon as you reach 15-25x of annual spending in savings. You are now free. If you can simply keep this cash in a mix of baskets of goods, you will unlikely have any money issues in your future. You can either take risk off the table (practically all of it) by leaving it entirely in low risk bonds and government backed securities. Or you can continue to grow your wealth (if you are young).

Please note that we assume you are near retirement at 10-15x annual income as savings… because many people will pick up a hobby or job they enjoy for minimal income. No need to retire and sit on the beach for the rest of your life.

Concluding Remarks

In our view, it is best to create a mixed bag as fast as possible. You work and have a solid career that pays well. You can create a small business on the side and create some location independent or even static business income. You then save cash by keeping your lifestyle in check and build up a nice nest egg that gives you momentum. You will see your portfolio gain momentum once you have ~ 8x annual spending in savings/investments.

At that point it is up to you. If you’re young we suggest keeping a bit more in the stock market and if you’re older then you dial back the risk and look at bonds/deposits.

Related: How To Build Passive Income For Financial Independence

Updated for 2017 and beyond.

Comments

    • Wall Street Playboys says

      Care to explain mike?

      Considering we receive thank you emails on a daily/weekly basis for helping people 1) obtain jobs, 2) obtain interviews and 3) change their mindset to savings + investing intelligently… Your comment is pretty unjust.

      If you disagree feel free to state a legitimate opinion.

  1. Mark says

    Great article guys. I like the allocation breakdown to look at saving multipliers along with age. Also, how would you view home equity in this breakdown?

    • Wall Street Playboys says

      We have a post on why we don’t believe in owning homes. It is a bit stale so we intend on updating it in the future.

      Basically, owning a home is not passive income so it was not included in this post. You have to factor in depreciation, interest rates, a fixed location, searching for a great renter (if you’re renting) and tax implications.

      TL-DR it requires monitoring unlike buying a CD where you sit back and do nothing.

  2. Withdrawal says

    The guidelines don’t seem right. Isn’t it conventional to have a hard stop at 20x? The 4% rule I think?

    • Wall Street Playboys says

      It certainly isn’t conventional as our advice is tailored to our own belief system:

      1) Retirement is a waste because you should enjoy your work
      2) Having a slightly riskier portfolio makes you work harder when you see a temporary correction
      3) We run the numbers at a net asset value of near zero at death assuming the reader does not wish to have a family

      If we make changes to these assumptions the model would certainly change.

    • Wall Street Playboys says

      Thanks, we simply write about the topic we feel interested in at the moment.

      Again if someone dislikes the posts/ideas… well they don’t have to read our blog.

  3. Student says

    Can you guys do an article on student debt? I think that would help with a lot of personal finance readers.

  4. Hans says

    Nice article!

    In my view your thresholds are a bit optimistic, though. Retiring with 15x annual spending (invested mostly in bonds) is quite risky unless you are already very old. Specifically, a net worth of 15x annual spending implies an annual withdrawal rate of 1/15 = 6.67% (even before inflation!). However, real returns on fixed income are close to zero at the moment for low risk bonds. Even if the money were invested in stocks instead, the risk would be very high that you eat up all the principal before you die.

    You can check historical survival rates and play with the numbers here: http://www.firecalc.com/

    For instance, assume you hold 75% equities and 25% bonds. Then with 15x spending, the likelihood to go broke and not make it through 30 years of retirement is larger than 60%!

    My own view would be:

    (i) If you retire at a “normal” retirement age (between 60 and 70), aim for net worth 25x annual spending and invest 50% in stocks post retirement.
    (ii) If you retire early (between 50 and 60), aim for net worth 30x annual spending and invest 60% in stocks upon retirement.
    (iii) If you retire very early (before 50), aim for net worth 35x annual spending and invest 70% in stocks.

    Of course these figures can (should) be adapted as bond returns change. If the market gives real returns of 5% in bonds again, as in the past, a significantly larger proportion can be invested in bonds.

    What do you think?

    • Wall Street Playboys says

      These numbers are great, the difference (we believe) is the discrepancy on what retirement is.

      In our opinion, retirement is a scam and it is good to keep the brain working. So think of it like this. 15-25 annual savings in assets. Then you simply work as you please. This could be 40-60 hours in a job you love or it could simply mean 20 or so… again in a job you enjoy.

      We don’t believe in getting to X dollars and sitting on the beach drunk for the rest of your life. You’ll get bored. Most people who are able to save this much and also obtain the needed assets in a fast way are intelligent and want to constantly improve.

  5. James Mark II says

    Awesome post. Might want to suggest forming a C or S corp and opening a brokerage account under the corp name, buying dividend paying stocks and pay very little taxes on that income.

  6. sb says

    I am self employed, far from Wall Street. In my business I have established two forms of passive income. 1 holding an exclusive contract with a large entity that involves regular, recurring work. In turn, I subcontract out 50 % of it. 2. Exclusive broker with another firm for raw materials. The entity pays me a commission on every ton of volume sent to them by any new supplier I have put on. The initial work to broker these deals usually involves at most 2 hrs. Once the deal is done I receive weekly checks for any material sent there way.
    Neither income stream is getting me rich but they truly are effortless sources of money

  7. Dan says

    You don’t mention real estate as passive income. I have 3 single family and am a passive partner in 5 apartment complexes. There are also royalties and oil and gas leases. I have a buddy with land in Texas which apparently generates significant income for the time being.

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