One of the keys to getting rich and creating wealth is to understand the different ways in which income
can be generated. It's often said that the lower and middle-class work
for money whilst the rich have money work for them. The key to wealth
creation lies within this simple statement.
Imagine, rather than
you working for money that you instead made every dollar work for you
40hrs a week. Better still, imagine each and every dollar working for
you 24/7 i.e. 168hrs/week. Figuring out the best ways you can make money
work for you is an important step on the road to wealth creation.
In
the US, the Internal Revenue Service (IRS) government agency
responsible for tax collection and enforcement, categorizes income into
three broad types: active (earned) income,
passive income,
and portfolio income. Any money you ever make (other than maybe winning
the lottery or receiving an inheritance) will fall into one of these
income categories. In order to understand how to become rich and create
wealth it's vital that you know how to generate multiple streams of
passive income.
Crossing the Chasm
Passive income is income generated from a trade or business, which does not require the earner to participate. It is often investment income
(i.e. income that is not obtained through working) but not exclusively.
The central tenet of passive income is that it can expect to continue
whether you continue working or not. As you near retirement you are most
definitely seeking to replace earned income
with passive, unearned income. The secret to wealth creation earlier on
in life is passive income; positive cash-flow generated by assets that
you control or own.
One of the reasons people find it difficult
to make the leap from earned income to more passive sources of income is
that the entire education system is actually pretty much designed to
teach us to do a job and hence rely largely on earned income. This works
for governments as this kind of income generates large volumes of tax
but will not work for you if you're focus is on how to become rich and
wealth building. However, to become rich and create wealth you will be
required to cross the chasm from relying on earned income to generating
sources of passive income.
Real Estate & Business - Sources of Passive Income
Passive
income is not dependent on your time. It is dependent on the asset and
the management of that asset. Passive income requires leveraging of
other peoples time and money. For example, you could purchase a rental
property for $100,000 using a 30% down-payment and borrow 70% from the
bank. Assuming this property generates a 6% Net Yield (Gross Yield minus
all Operational Costs such as insurance, maintenance, property taxes,
management fees etc) you would generate a net rental yield of
$6,000/annum or $500/month. Now, subtract the cost of the mortgage
repayments of say $300/month from this and we arrive at a net rental
income of $200 from this. This is $200 passive income you didn't have to
trade your time for.
Business can be a source of passive income.
Many entrepreneurs start out in business with the idea of starting a
business so as to sell their stake for some millions in say 5 years
time. This dream will only become a reality if you, the entrepreneur,
can make yourself replaceable so that the business's future income
generation is not dependent on you. If you can do this than in a way you
have created a source of passive income. For a business, to become a
true source of passive income it requires the right kind of systems and
the right kind of people (other than you) operating those systems.
Finally,
since passive income generating assets are usually actively controlled
by you the owner (e.g. a rental property or a business), you have a say
in the day-to-day operations of the asset which can positively impact
the level of income generated.
Passive Income - A Misnomer?
In
some way, passive income is a misnomer as there is nothing truly
passive about being responsible for a group of assets generating income.
Whether it's a property portfolio or a business you own and control, it
is rarely if ever truly passive. It will require you to be involved at
some level in the management of the asset. However, it's passive in the
sense that it does not require your day-to-day direct involvement (or at
least it shouldn't anyway!)
To become wealthy, consider building
leveraged/passive income by growing the size and level of your network
instead of simply growing your skills/expertise. So-called smart folks
may spend their time collecting diplomas and certificates but wealthy
folk spend their time collecting business cards and building
relationships!
Residual Income = A Form of 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 yet
important difference between the two. It is income that is generated
from time to time from work done once i.e. recurring payments that you
receive long after the initial product/sale is made. Residual income is
usually in specific amounts and paid at regular intervals. Some example
of residual income include:-
- Royalties/earnings from the publishing of a book.
- Renewal commissions on financial products paid to a financial advisor.
- Rentals from a property letting.
- Revenue generated in multi level marketing networks.
Use of Other People's Resources and Other People's Money
Use
of Other People's Resources and Other People's Money are key ingredient
required to generate passive income. Other People's Money buys you time
(a key limiting factor of earned income in wealth creation). In a
sense, use of other people's resources gives you back your time. When it
comes to raising capital, businesses that generate passive income
usually attracts the largest amount of Other People's Money. This is
because it is generally possible to closely approximate the return (or
at least the risk) you can expect from passive investments and so banks
etc., will often fund passive investment opportunities. A good business
plan backed by strong management will usually attract angel investors or
venture capital money. And real estate can often be acquired with a
small down payment (20% or less in some cases) with the majority of the
money borrowed from a bank typically.
Tax Benefits of Passive Income
Passive
income investments often allow for the most favorable tax treatment if
structured correctly. For example, corporations can use their profits to
invest in other passive investments (real estate, for example), and
avail of tax deductions in the process. And real estate can be "traded"
for larger real estate, with taxes deferred indefinitely. The tax paid
on passive income will vary based on the individual's personal tax
bracket and corporate structures utilized. However, for the purposes of
illustration we could say that an average of 20% effective tax on
passive investments would be a reasonable assumption.
In summary:
For
good reason, passive income is often considered to be the holy grail of
investing, and the key to long-term wealth creation and wealth
protection. The major benefit of passive income is that it is recurring
income, typically generated month after month without a great deal of
effort by you. Building wealth and becoming rich shouldn't be about
extracting every last bit of your own energy, your own resources and
your own money as there is always a limit to the extent you can do this.
Tapping into the effective generation and use of passive income is a
critical step on the road to wealth creation. Begin this part of you
wealth creation journey as early as is humanly possible i.e. now!
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