Passive, Residual, and Portfolio Income
Gen X Finance recently ran a poll: “How do you envision your retirement”. I chipped in with my little comment about having my monthly passive income reach roughly 1.5 times my monthly expenses. Since then I have been giving the concept a bit more thought, since the idea of not having to physically work for my money is very sweet indeed. I found out that under the passive income “umbrella” there actually are several different concepts: passive income, residual income, and portfolio income. They are similar, but not to the point of being mistaken for one another.
What passive income is
In the strict sense, defined by the Internal Revenue Service), passive income is income derived from business investments in which the individual is not actively involved. The best example would be where you start a business and make it successful to the point where you can hand it over to a management team and just collect your profits. For instance, the respective founders of Google, eBay, and Microsoft are now enjoying passive income generated by those companies. All those companies have CEOs and an entire management team running their day-to-day operations, while the founders are just overseeing strategic decisions and in many cases pursuing other ventures. It’s important to point out that passive income does not include earnings from wages or active business participation.
Another popular example is real estate. If you own investment property and are getting a positive cash flow from a house, commercial property, or apartment, that is passive income. If you rent rooms in your house, that’s passive income too. You only have to set this up once, and then the income comes in month after month.
What residual income is
Simply put, residual income can be defined as any payment system where you receive regular, ongoing payments as a result of performing a single service of making a single sale. Owners of intellectual property, such as art, books, lyrics, music, movies, and patents, typically get paid over and over as long as their property is being used. Sales people that sell services, subscriptions, or renewable products (like insurance) sell that item once and, providing the customer renews, will get a commission off of each renewal.
What portfolio income is
It includes interest, dividends, royalties, and gains from investments that are NOT passive investments. Portfolio income is also derived from paper assets such as stocks, bonds, and mutual funds, CDs, and so on.
What are the advantages?
The biggest advantage of those income sources is that they require little effort to maintain. From a tax standpoint, not only are they subject to a lower tax rate, but they offer many more loopholes that earned income (which is when you sell your time in exchange for compensation) and can result in a (proportionately) lower tax bill. Disclaimer: I am not a tax specialist. Always consult with a professional before making any tax-related decision.
What are the disadvantages?
To make a long story short, it requires a lot of time, effort, and often capital to build any of those streams to a decent level. That’s probably the reason why more people don’t go that route.
Take control of your life
I like to call those income streams “little work income”. Notice that they’re not “no work income”. It takes a lot to get the ball rolling, but once it does, the reward is fantastic. I’ve been around enough people who have managed to achieve this. I know that’s what I want. Let’s face it, most of us hold jobs just because we need to feed our families and pay the bills. Looking into “little work” income streams and investing your time and money can be incredibly gratifying. Getting paid every month, no matter if you work or not, is fun, Being able to spend quality time with your family, though, is literally priceless.
May 1st, 2008 at 12:06 pm
Your information regarding Real Estate investments and passive income is not quite correct. In many cases positive cash-flow property income will be considered passive income, but there are three different characterizations of real estate investors. The first is the passive income variety the other two move more of the income to non-passive; which is important because passive income is treated differently at tax time.
May 1st, 2008 at 12:43 pm
Thanks Bill. Can you elaborate on your comment? If yes I can update the post or maybe put up a corrective post. I’m all for providing my readers with accurate information, so I’d definitely like to hear more from you about it