What is passive income?

Most people rely on one stream of income — their salaried job. But if the past couple of years has taught us something, it’s that external factors can take away your job in an instant. Hundreds of thousands of workers were displaced during the pandemic. But in addition to job insecurity, data shows that incomes have stilled, and the costs of housing and education have soared. 

This information is not meant to scare you. It is given to point out the fact that there are many good reasons to consider drawing earnings from two or more sources. It might not be for everyone, but it’s worth investigating how to build a passive income online first.

If you think it’s too late to act, remind yourself of this ancient Chinese proverb: “The best time to plant a tree was 20 years ago. The second-best time is today.”

Background info: definition and examples

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Passive income describes earnings that are derived without one’s active involvement. If you receive regular earnings from a source other than an employer or contractor, it counts as passive income. 

There are three models for creating a passive income stream:

  • Buying investments (financial assets, properties, businesses)
  • Creating (products that generate cash, often digital)
  • Contributing (limited partnerships, subletting) 

A few couple examples are:

  • Dividend stocks
  • High-yield savings account
  • Real estate investment trust
  • Rental income
  • AdSense (website, blog, or YouTube videos)

Passive income isn’t only for people who don’t love their jobs or who don’t make enough money. But chances are, you wouldn’t mind making more income with less effort than an extra job. In an ideal scenario, you can increase your wealth, build an emergency fund, and perhaps retire early. 

A deeper look at passive income

Passive income is not hard to understand. Once you learn more about it, you’ll have an easier time finding ways to make this kind of income. To begin with, you should know there are three main categories of income: passive, active, and portfolio income.

Out of the three, passive income refers to earnings from limited partnerships, rental properties, and different businesses where a person is not involved actively. Aside from that, it can include interest made from dividends paid out by stock investments, unemployment benefits, or a savings account or bond.

Over the last few years, passive income has become more and more popular. Most people use it to refer to money that they regularly make without making lots of effort. However, you will notice that everyone you ask will give you a unique answer.

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The IRS also has a different opinion on what is considered passive income. When talking about passive income, they mostly refer to income from a business in which a taxpayer does not participate materially. It also includes net rental income, as well as self-charged interest.

Under the IRS, lots of things that would usually be considered passive income are ruled out. These include royalties, annuities, dividends, and interest that are not derived in the usual course of a business or trade. Income that is derived from debt cancellation or income tax refunds is also ruled out.

Not only are there different types of income, but also different types of passive income. Actually, there are three main types of passive income in total. These include self-charged interest, “no material participation” businesses, and rental properties.

Reasons for building passive income

You may be wondering why someone would consider making passive income, especially when they already make enough active income. Well, passive income has its own benefits, especially when you need that extra amount of cash.

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For the most part, even if a person has a full-time job and earns a lot of money, they wouldn’t say no to an additional money source, especially since it doesn’t require a lot of effort.

When an individual can make passive income, they will have the opportunity to grow their wealth-building base. This way, it will be possible to retire earlier and have enough money to live comfortably.

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And in the event the person loses their job, passive income can work as an alternative when the retirement plan is outlived by the retiree.

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How much income can be made?

How much income you can make depends on how much time you spend on it. You should be aware that you will not turn rich overnight through passive income, so you shouldn’t rely on it too much if you need an urgent amount of cash. It will not bring huge sums instantly.

At the same time, if you keep gaining passive income over a long period, you may be able to earn some decent sums. It’s possible to get a few hundred to thousand dollars over an extended period.

How much money do you need?

Let’s say you want to make $4,000 a month ($48,000 a year) from investments:

  • Rental properties (expected yearly return in rent of 8%): You’ll need to invest $600,000 upfront;
  • S&P500 index (average return of about 10%): You’ll need to put up $480,000 in the index.

These figures may sound daunting, so let’s set the bar lower at $100 a month ($1,200 a year): 

  • Rental properties (expected yearly return in rent of 8%): $15,000
  • S&P500 index: $12,000

As you can see, even generating $100 a month requires a hefty upfront investment. Here is a compromise: pick an income stream that is not entirely passive or turn the things you already own into income-producing assets.

How long does It take to build wealth passively?

When it comes to setting timeframes, remember two things: 

  1. Passive income takes time to develop.
  2. Don’t expect instant results from passive income investments online.
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The goal of the first few steps is about setting up properly — educating yourself about business, finance, and investments, experimenting, and starting small. Many people expect to succeed on their first try, but it’s rarely the case. 

You can’t build a successful income stream in a day, a week, or sometimes, even a month. In the beginning, you’ll be navigating an unknown territory with a higher risk of failure. So, set aside a few months and extra capital to figure everything out at your own speed.

Just how “passive” is passive income?

“A lot of people are surprised by how much work it takes… a lot of people who are earning a passive income don’t necessarily tell you the whole truth”.

entrepreneur and creator of the Smart Passive Income podcast

Passive income is not actually created passively – it’s not a lottery. Whether you buy stocks, rent out properties, sell digital properties, or earn royalties/ad revenue, you will need to do some work upfront. Before anything starts generating money, you’ll need to arrange it, streamline it, and maintain it. 

Besides, there is no clear-cut point where income turns passive. You may be required to do “minimal work” to keep the funds flowing.

Can you make a living from passive income?

It depends on various factors. As for investing, the biggest determining factor is the size of your investment. Also, the longer your positions stay open in the market, the more opportunity there is for your investments to go up. Successful companies increase their profits over time and raise their dividend along with them.

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If you have a thought-out plan, you can scale up to the point where your passive income matches and even surpasses your active income. But prepare yourself for a long journey before you get to this point. It’s important to be reasonable and make calculated decisions — ones that do not involve you leaving a well-paying job for a risky investment.

Takeaway: what you need to know about building passive income

How to spot passive income scams? Watch out for:

  • Promises of easy and fast earnings: Get-rich-quick dreams are often taken advantage of. There have been too many Ponzi schemes preying on people desperate for money. 
  • Aggressive sales techniques: Whoever urges you to act quickly before the opportunity ends should not be trusted. Yes, you can miss out on valid time-sensitive options, but always give yourself some time to think and reassess. 
  • Companies that don’t sell real products or offer services: Avoid companies that don’t offer anything of value.

Passive income comes down to making long-term commitments and short-term trade-offs. You have to be willing to give your time, skills, and money to reach your goal.  

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