In general, passive income comes from putting something you own – property, money, expertise that you share, say, in a Youtube video – to work. The revenue you collect in rent, dividends or ad sales are all forms of passive income. Of course, as these examples demonstrate, passive income still requires some effort or labor at least initially. In that sense, the “passive” in passive income is not really the opposite of active. Rather, passive income is meant in contrast to earned income, as defined by the IRS.
Whether your income is passive or earned really only matters when you’re filing your tax returns (e.g., you can’t claim passive income losses against earned income). That said, the IRS differentiates investment income from passive income, though they are both taxed at capital gains rates. For a better understanding of passive income and ways to make it, continue reading. If you’re looking to increase your investment income, a financial advisor can help.
Find out if you’re on track for retirement savings.
What Is Passive Income?
As defined by the IRS, passive income is when you make money from an enterprise where you’re not materially involved. This means you’re the silent partner, the investor, the person who is not running the show.
The IRS gives more specific limitations as to what “material participation” means. For one, you must work at least 500 hours in a year on the project or more than 100 hours when no one else works more than you. Or if you contributed almost all of the work on a project, it’s considered material involvement. Likewise if your work in multiple significant participation activities (SPAs), combined, exceeds 500 hours, it counts as material participation. There are a few more criteria that would qualify a project as material. You only need to meet one to qualify.
As mentioned earlier, passive income differs from earned income and portfolio income. Earned income is wages, salary, tips, bonuses, commissions and net gains from self-employment. Portfolio income, on the other hand, is dividends, interest and capital gains. Significantly, passive and portfolio income are not subject to Social Security or Medicare taxes. They’re also taxed at different rates than income taxes.
There are a ton of ways to make passive income. As we said above, not all methods are entirely passive. Let’s take a look at the top ways to make passive income based on their levels of involvement.
Top Ways to Make Passive Income – Less Involvement
Passive income that takes next-to-nothing involvement is the dream. That’s probably a large part of the appeal of robo-advisors. You fund the investment account, and an algorithm keeps your balance growing.
Of course, you can also hire a human to manage your investments. Human financial advisors typically cost more than a robo-advisor, but they can take unusual conditions, like a market sell-off, into account in a way that a computer program can’t. They also can listen, answer questions and provide guidance. For help finding the right financial advisor for you, use our free matching tool.
If you want to do the investing yourself, dividend stocks are a popular source of passive income. Of course, you’ll have to do your research and pay attention to the market, but assuming you find great dividend stocks, you won’t have to do much more. If you have a lower tolerance for risk, you could simply open a high yield savings account or build a CD ladder. Again, you’ll have to do your research to find the right ones and keep an eye on the accounts to make it a successful source of income.
Top Ways to Make Passive Income – Medium Involvement
For medium-involvement passive income, you could buy real estate and rent it out. Similarly, you could buy a business and then have someone else run it for you. Both examples involve research, work and money at the start. But after the initial investment, you are mostly just depositing checks.
If you have anything in excess, like house space, cars or even your driveway, you can consider renting them out. Since you already own these items, you wouldn’t have to go around buying new things. Simply list these things somewhere, like a room on Airbnb, to get started. You will probably have to put in some time and money for the upkeep, but otherwise it’s a pretty passive venture.
If you have expertise in something, you could create an online course. Sites like Udemy can help you do this. It requires some work to create the course, but once it’s available online, you get paid as people sign up to take it.
Top Ways to Make Passive Income – More Involvement
One way to make passive income with more involvement is to write and publish an e-book. Got some knowledge or a great story idea you’ve been itching to share? Put it all in a book and sell it online! If all goes well, you could be raking in the royalties for years to come. Of course, there is some considerable work involved in writing, publishing and selling a book. However the advent of self-publishing e-books makes this a considerably easier option than it used to be.
Of course, a book isn’t the only way to get your thoughts to the world nowadays. You could also start a blog, website or YouTube channel to earn some passive income. Besides the creation of your website, videos and content, sharing your ideas and advice online seems pretty passive. However, it will take a lot of work on your part and time to gain readers, followers and then paid advertisers. You will need to make your content marketable and appealing. That way you continue to gain followers, advertisers and money.
Further playing off of your talents and ideas, you can easily sell products online nowadays, too. Find companies where you can sell your musical talents for jingles. Look for companies who need freelance designers. While you can earn passive income through these royalties, again, it will take time and work to produce your craft, whatever it may be.
If you happen to be technologically inclined, you could consider making a smartphone app. This isn’t easy, nor a passive project. However, once you complete the right app, you could see a steady passive income for many years.
Overall, generating passive income only has an upside. The idea is to make money while you go about the rest of your life, either working at your day job or, if your passive income is large enough, doing whatever you love. Disruptive companies that allow people to, say, rent out their rooms or sell their online course have made passive income more possible to more people. YouTube and other social media platforms have created a whole profession of social influencers who earn passive income from advertising sales.
If there is a downside to passive income, it’s that it can turn preparing your tax return into a major headache. You need to keep very good records – and you’ll probably want a tax expert’s help. The IRS has different rules and rates regarding rental income, investment income, royalties and more.
Tips for Increasing Investment Income
- Keep costs down. When choosing mutual funds, look at their expense ratios. Generally, you want them lower than 1%. If you’re going to buy exchange-traded funds (ETFs) or individual stocks, make your trades online. Many brokerages, including Charles Schwab, E-Trade and TD Ameritrade offer no-commission online trades.
- Don’t go it alone. A financial advisor who has a good (and long) track record can help you maximize returns within your comfort level for risk. To find an advisor, use SmartAsset’s matching tool. It is free, takes five minutes and will recommend up to three fiduciary advisors based on your preferences.
Photo credit: ©iStock.com/Ridofranz, ©iStock.com/izusek, ©iStock.com/Wavebreakmedia