One key to becoming wealthy and creating wealth is understanding the different ways to generate income. It is often said that the middle and lower classes work for the money, while the rich make the money work for them. The key to wealth creation lies in this simple statement.
Imagine that instead of working for the money, you made every dollar work for your 40 hours a week. Better yet, imagine every dollar working for you 24 hours a day, 7 days a week - 168 hours a week. Finding the best ways to make money work for you is an important step on the road to wealth creation.
In the United States, the Internal Revenue Service (IRS), the government agency responsible for collecting and enforcing taxes, classifies income into three broad categories: active (earned) income, passive income and portfolio income. Any money you ever earn (except maybe winning the lottery or receiving an inheritance) will fall into one of these income categories. To understand how to get rich and create wealth, it’s essential that you know how to generate multiple passive income streams.
Crossing the chasm
Passive income is income generated from a business or enterprise, which does not require the participation of the recipient. It is often investment income (i.e., income that is not earned by working), but not only. The central principle of this type of income is that it can continue whether you continue to work. As you approach retirement, you are most likely looking to replace work income with passive, unearned income. The secret to early life wealth creation is passive income, which is positive cash flow generated by assets you control or own.
One reason people have trouble shifting from labor income to more, we actually designed passive sources of income is that the entire educational system to teach us to be employed and thus to depend heavily on labor income. This works for governments because this type of income generates large volumes of taxes, but it won’t work for you if you focus on becoming rich and creating wealth. However, in order to become rich and create wealth, cross the chasm that separates you from just labor income.
Real Estate and Business - Passive Income Sources
Passive income is not dependent on your time. It depends on the asset and the management of that asset. Passive income requires taking advantage of other people’s time and money. For example, you may purchase a rental property for $100,000 with a 30% down payment and borrow 70% from the bank. Assuming that this property generates a net return of 6% (gross return minus all operational costs such as insurance, maintenance, property taxes, management fees,.), you would get a net rental return of $6,000 per year or $500 per month. Now subtract the cost of paying off the mortgage, say $300/month, and you get a net rental income of $200. That’s $200 of passive income that you didn’t have to trade your time for.
Business can be a source of passive income. Many entrepreneurs go into business to create a company to sell their stake for a few million in, say, 5 years. This dream will only become a reality if you, the entrepreneur, can make yourself replaceable so that the future income generation of the business does not depend on you. If you can do this, you will have created a passive income stream of sorts. For a business to become a true passive income source, you need the right systems and people (other than you) to operate those systems.
Finally, because passive income generating assets are usually actively controlled by you, the owner (e.g., a rental property or business), you have a say in the day-to-day operations of the asset, which can have a positive impact on the level of income generated.
Passive income - a misnomer?
In some ways, the term “passive income” is a misnomer, because there is nothing truly passive about being responsible for a group of income-producing assets. Whether it’s a portfolio of real estate or a business that you own and control, it’s rarely, if ever, truly passive. You will need to be involved at some level in the asset's management. However, it is passive in the sense that it does not require your direct day-to-day involvement (or at least it shouldn’t!).
To get rich, consider creating leveraged/passive income by increasing the size and level of your network instead of just developing your skills/expertise. So-called smart people may spend their time collecting degrees and certificates, but rich people spend their time collecting business cards and building relationships!
Residual income = passive income
Residual income is a form of passive income. The terms “passive income” and “residual income” are often used interchangeably; however, there is a subtle but important difference between the two. It is income generated from time to time from work done once, i.e. recurring payments that you receive long after we have sold the initial product. Residual income is usually made up of specific amounts and paid at regular intervals. Examples of residual income include.
- Royalties/gains from the publication of a book.
- Financial product renewal commissions paid to a financial advisor.
- Rental income from a real estate lease.
- Income generated by multi-level marketing networks.
Use of other people’s resources and other people’s money
Using other people’s resources and money is a key ingredient in generating passive income. Other people’s money saves you time (a key limiting factor of earned income in wealth creation). Using other people’s resources gives you your time back. In raising capital, businesses that generate passive income attract the most money from others. This is because it is usually possible to closely approximate the return (or at least the risk) you can expect from passive investments, and banks, etc. often fund passive investment opportunities. A good business plan backed by strong management will usually attract angel investors or venture capital. And we can often gain real estate with a small down payment (20% or less sometimes), with most of the money usually borrowed from a bank.
Tax advantages of passive income
Passive income investments often provide the most favorable tax treatment if structured properly. For example, companies can use their profits to invest in other passive investments (real estate, for example) and receive tax deductions. And real estate can be “exchanged” for more real estate, with taxes deferred indefinitely. The tax paid on passive income varies depending on the individual’s personal tax bracket and the business structures used. However, for illustrative purposes, we could say that an average of 20% effective tax on passive investments would be a reasonable assumption.
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Bottom line:
For good reason, we often consider passive income the Holy Grail of investing, and the key to long-term wealth creation and protection. The primary advantage of passive income is that it is recurring income, usually generated month after month with little effort on your part. Creating wealth and becoming rich should not be about extracting every bit of your own energy, resources and money, as there is always a limit to what you can do. Harnessing the effective generation and use of passive income is an essential step on the road to wealth creation. Start this part of your wealth creation journey as early as humanly possible, which is now!
