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Tuesday, July 13, 2010

Financial Freedom through Passive Income

The easiest way to gain financial independence is to reconfigure your life so that a substantial portion of your income is not actively earned by your labor. Instead, it must come from passive income. In fact, the idea of passive income is closely related to the Berkshire Hathaway model, which we explained in our earlier article.

The basic idea of passive income is that it is money received with little or no effort required to maintain the flow of income once the initial work has been done. Some common examples of passive income are:
  • Rent from real estate properties
  • Patent royalties for an invention
  • Trademark licensing fees for characters or brands you’ve created
  • Royalties from books, songs, publications, or other original works
  • Profits from businesses in which you have little or no day-to-day role or responsibility
  • Dividends from stocks, REITs, equity mutual funds, or other equity securities
  • Interest from owning bonds, certificates of deposit, other other cash and cash equivalents
  • Pensions 
Why You Should Prefer Passive Income to Active Income

Passive income is attractive because it frees you to spend your time on the things you actually enjoy. A highly successful doctor, lawyer, or publicist, for instance, cannot “inventory” their profits in the words of one well known author. If they want to earn the same amount of money and enjoy the same lifestyle next year (the year after that), they must continue to work the same number of hours at the same pay rate. Although such a career can provide a fantastic life, it requires far too much sacrifice unless you truly enjoy the daily grind of your chosen profession. Even worse, once you desire to retire, or find yourself unable to work any longer, your income will cease to exist unless you have some form of passive income. In the past, this was accomplished by employee participation in company-sponsored pension plans.

The Two Broad Types of Passive Income

There are two types of passive income and throughout your career, which ones you focus on will likely depend upon your current financial situation, talents, skills, and personality. The two categories of passive income are:
  1. Passive income sources that require capital to start, maintain and grow
  2. Passive income sources that do not require capital to start, maintain, and grow
Those who choose to focus on the first category of passive income will need either family money, funds from investors, or the nerve to borrow large sums by taking on debt to fund the purchase of assets. The easiest to understand is someone who takes out substantial bank loans to build an apartment building or buy rental houses. Although this can turn a very small amount of equity into a large cash flow stream, it is not without risk. When using borrowed money, the margin of safety is much smaller because you can’t absorb the same degree of setback before defaulting and finding your balance sheet obliterated.

Another example of the first category of passive income is someone who has an ownership stake in an operating business such as a factory or furniture store and allows the business to issue debt to fund expansion. The early store managers in Wal-Mart who were allowed to invest before the company went public were in this position.

Large investment portfolios also fall into this category of passive income. If owned Rs. 10,000,000 worth of blue chip stocks, you could reasonably expect dividends of Rs. 500,000 per year. Whether or not you spend your days playing golf, painting, or writing the great American novel, you would collect checks as those businesses paid out a portion of their earnings. The problem, of course, is that it takes the ten million to be in that position.

The second category of passive income - that is, passive income sources that do not require capital to start, maintain, and grow - are far better choices for those who want to start out on their own and build a fortune from nothing. They include assets you can create, such as a book, song, patent, trademark, Internet site, recurring commissions, or businesses that earn nearly infinite returns on equity such as a drop-ship ecommerce retailer that has little or no money tied up in operations but still earns profits for the owner.

The Path Most Often Taken to Passive Income

It seems that most common path to generating large passive income streams is to work at a primary job and use your actively earned income to buy assets that generate passive income on a regular basis.
The doctor or lawyer in our earlier example, for instance, could use his income to invest in a medical start-up or buy shares of medical companies he understands such as Johnson & Johnson. Over time, the nature of compounding, rupee cost averaging, and reinvesting dividends will result in his portfolio generating substantial passive income. The downside is that it can take decades to achieve enough to truly improve your standard of living but it is still the surest way to wealth based on the historical performance of business ownership and stocks.

Taxes and Passive Income

A major advantage of earning passive income is that it is often taxed more favorably than active income. That may seem unfair, but the idea is that it will give people an incentive to invest in assets that will grow the economy and create jobs.

A business owner that works in his company, for instance, would have to pay extra in self-employment payroll taxes compare to someone who merely had a passive interest in the same limited liability company who would pay only income taxes. In other words, the same income earned actively would be taxed at a higher rate than if it were earned passively.