Creating Financial Independence: The Importance of Passive Income
Is financial independence having enough to pay the bills coming in at the end of this month? Is it to have a six month expense buffer recommended by most financial experts? Is it not having to worry about how and where the next paycheck will come from?
The answer is partly all, depending on your current estate and perspective on financial independence. In my opinion however, financial security is having a diversified set of resources that I can count on to ensure I have the cash I need to live the kind of life I want.
Because the kind of life I want to live is different from the kind of life you want to live, there is no objective answer to quantifying financial security. Only you can answer that for yourself. But whatever it may mean to you, it is important to realize how establishing streams of passive income can contribute to financial independence and security.
Passive income is a key component of financial security because it doesn’t rely on you having to invest the time to get paid for it. In other words, you are not trading hours for dollars. When you set up a passive income stream, you are entitled to the profits generated by the stream even when you are not actively working on it.
Because you are not relying on an employer to pay you, having a passive stream of income to rely on gives you more freedom, flexibility and thus financial independence. You can choose what you want to do, when you want to do it and how you want to do it all without having to worry about how the bills will be paid, or where the next paycheck will come from.
Because passive income doesn’t require much active work, your time is freed up to work on other passive income endeavors, thereby multiplying the income effect from your passive activities. This will allow you to establish a 6 month or more buffer, pay your bills and not worry about your incoming cash to match the expenses demanded by your lifestyle.
By growing your passive income stream to a point where money is no longer a stress factor in your life, you will have attained what many refer to as financial security or financial independence. Establishing multiple streams of passive income is one way to grow your passive income stream.
Role of Taxes and Money Management in Creating Financial Independence
Establishing multiple sources of passive income will provide you with tax planning tools you can utilize to reduce your tax burden. Taxes are one of our biggest expenses. Read my discussion on your effective tax rate to truly understand how much of your paycheck is going to Uncle Sam.
When you have financial security, you can afford to hire a talented CPA (like me ;)), who can help you maximize your tax advantages and at the same time ensure that you are complying with the income tax laws and regulations.
You will also benefit from becoming a better money manager when you start to move toward financial independence. When you start to understand the relationship between your passive income profits, taxes and reinvestment of those earnings, you will begin to view money the way the more affluent folks do.
When you are making a good amount of money, you can reinvest your earnings in more resources that will yield passive income while benefiting from a lower tax burden. Your CPA will also require you to record and track your financial activities.
Becoming financially secure or independent is one thing, maintaining it is another. Maintenance takes some work just like anything worthwhile in life. Learning to manage your passive earnings is a key step on the way to financial freedom.
When you change your perspective on earning and money management, you take a large step toward a more permanent state of financial independence. That my friend is advice from first hand experience.
Readers: How do you define financial independence?
Here is how the Wiki contributors define financial independence.
Sunil
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Sunil, thanks for your post. What % of your income is passive and what % is active?
without dissecting it completely, which i have never done before and thanks to your inquiry i now definitely want to do that, it is currently 50/50. it was 60/40 not long back favoring passive, but i disposed a couple cash generating assets which although improve the net worth, take away from the income stream/flow.
i am very much interested in what the true numbers are. for example, i’d like to apportion the active work done on real estate into the active bucket, and the rest to the passive (i.e. work done by property managers). my estimate above doesn’t account for such nuances.
what about you, how does the percentage(s) break down for you?
is there a target you are shooting for?
My passive income percentage is probably only around 5% of my total income b/c my main income is relatively high (think Obama target). Also, I don’t believe there is true passive income except for cash in the bank earning interest.
Ideally, I’d like my passive income to reach 100%, but I know that’s not possible. So the interest from cash will hopefully reach 30% in 10 years. Cheers
cash in the bank is indeed the truest form of passive income. but what about dividend yields?
some argue that interest rate hunting, pulling and redepositing are all “activities” thereby not making interest truly passive?
interest reaching 30% of income is a very good goal, and I hope the deposits are diversified to fall under FDIC insurance. but then again, diversifying can potentially lead to less interest rate negotiation leverage with the financial institutions.
I’ve got money spread out over 4 different banks due to the $250,000 FDIC limit. I didn’t want to risk losing the money when the economy was detonating, and have just left it.
Dividends are passive, but the issues is, you can get a nice 6% dividend yield, but you have principal risk… stock goes down 10% and you’re in the red.
True – cash is definitely a more conservative play. Living off of interest income from cash deposits is the way to go.
Unfortunately, it’s a goal not obtainable for most people. And for those that it is, there is always a possibility of leaving too much untouched / behind and ending up paying a whopping amount in estate/transfer taxes.
For someone who is nearing that stage, any advice for our readers on the most optimal way to manage the cash balance/distribution schedule?
I bought a good amount of Gold when the economy started to detonate couple years back. It’s paid off well. Some say it’s too high (overpriced), but I’m riding it out.
I think passive income is one of my favorite things to discuss! I would love to make enough money through passive, regenerative income so that I could quit my job!
I started my website for this purpose, and it’s starting to gain readership, but I think I still have a long way to go.
When I make it to the point where I can get rid of the job, I would love to help others do the same!
LifeAndFinances,
Welcome first of all. Your plan sounds good, and is one that many share. Here is a post you might enjoy:
http://easyextramoneyonline.com/blog/2010/10/why-even-little-passive-income-is-worth-more-than-you-think/
I have never heard of the term “regenerative income” – good call. I refer to it in the same old way – residual income.
I’m very weak on passive income currently, but I’m starting to build up some assets to generative such income. Hopefully the trend will continue!!! 50/50 looks like a great mix to me!!!
MR – What are some of your favorite avenues to generate PI? Care to share what you are pursuing?
I do agree that passive income is important. I am more focused on passive income from investments. I do have interest in real estate some day but I have a feeling it won’t happen in Vancouver with the current prices… I basically want to make sure my money works for me.
I am not sure blogging is passive income though … I tend to agree with Financial Samurai. Writing a book and selling it may be more of a passive income stream than blogging but it required some work up front although with possibly a long timeline of income.
I made 7.30% (~3700$) in dividends from my investments this year but that’s only a really small part of my income. I am years away from reaching 50%. This is where I am hoping compound growth will kick in.
Welcome TPIE first of all
Making our monies work for us is definitely a winning approach. The downside of income from investments (assuming capital markets from your post) is principal risk as FS stated. However, the upside is definitely lucrative. That said, do not forget to factor in tax implications to come up with your tax adjusted return on investment.
Writing and selling a book/ebook is one of the most lucrative and passive ventures. The challenge here is distribution. I have 6 ebooks that sell on various nice content websites and 3 in the works. I can tell you that the experience has been extremely rewarding.
The key is to have a website that is optimized well enough to index high in search rankings so people can find the book. In addition, capitalizing on various other channels (i.e. Amazon Kindle) amplifies the benefits.
To your point about blogging, I agree, it can never be a truly passive venture. But over time, the effort invested is significantly less than benefits realized. It also depends on your long term goals. There are several monetization methods a blogger can apply to automate revenue generation from a blog, such as affiliate promotions of products and services that pay residual/recurring commissions.
Whatever the management of your employer says about the promise of your career with them, the truth is that working for daily wages does not leave you with much after retirement. In fact, even for your daily expenses, your salary may not leave much room for comfort. Most of the time, people get paid the minimum possible. The computation of this amount is mainly based on daily necessities. The end result is that people are strapped for cash most of the time. They either overspent on their entertainment and luxuries or experienced emergencies which upset their monthly budget.
very true Andreas. most people certainly fit in this category. that said, there is still a lot of good things to be said about a lucrative career in corporate America don’t you think?