How to Build Wealth Through Passive Income

Everyone can use a little more cash. One of the more practical and flexible ways to earn extra money, without taking on a second job—which, face it, isn’t always practical or flexible—is through passive income.

Passive income is becoming popular as traditional work is changing and people seek additional ways to reach their financial goals. Below, we look at various opportunities to earn passive income, along with the costs and risk involved. 

What is passive income?

 There are three main categories of personal income: active income, investment income and passive income.

1. Active, or earned, income is the most common type. It encompasses the money you make from employment, including wages, tips and commissions.
2. Investment income is the money you make from investments, such as stocks, bonds, mutual funds, and various forms of alternative investments. While many types of investment income can be considered passive income; here, investments for the purpose of long-term appreciation towards your retirement goals for example, are distinguished from investment income that also produces an income stream apart from appreciation.
3. Passive income is money you don’t earn from a job or through traditional investments. Although launching a passive income venture will take an initial investment of time, money or effort, the goal is to create an income stream without devoting substantial resources or effort to it.

6 Popular Passive Income Opportunities

There are many ways to make passive income. Determining the best fit for you depends on your particular situation. Factors to consider include your interests and skills, how much time you have to devote to a particular venture, the amount of money you have to invest, and your risk tolerance. Some opportunities, such as a real-estate investment, typically require a larger initial capital investment and have higher risks, while others, like licensing stock photography or building a mobile app, require a greater upfront time commitment.

Here are six of the most popular passive investment opportunities:

1. Rent out your property.

Renting your home or apartment—or part of your property—can provide a steady stream of passive income. You can lease your property as a long-term rental or earn money with short-term rentals through Airbnb, Booking.com, VRBO and similar platforms. You can also rent unused portions of your property, such as a room or building that can be used as a storage space or a parking space in your driveway.

Keep in mind: Renting out your property is dependent on you having extra space in your home or a second home, and it can also come with a loss of privacy, particularly if you are still residing there. You’re also on the hook when things break, and when stuff needs cleaning.

If you don’t have the flexibility for a rental arrangement, taking in a roommate can also provide a passive income source through rent and shared expenses but again, you are trading some privacy and autonomy.

2. Invest in real estate.

Buying residential or commercial property with the intent to rent is another popular way to earn passive income. While long-term investments in real estate with the goal of having that property appreciate over time can be viewed as a traditional investment, the money earned through rent as that property appreciates can be viewed as passive. This is a long-term commitment, but once you are able to rent the property and create a management structure, it can provide substantial passive income.

Before diving in, it’s important to remember that owning rental property comes at a great cost, with many potential headaches. Similar to renting out your property, you would be responsible for managing and maintaining the property as well as collecting rent. If you are not able to find renters, you’re still responsible for the mortgage payments and other property costs.

Another more “passive” passive way to invest in real-estate is through Real-Estate Investment Trusts (REITs), which are securities based on income-producing real estate that trade like a stock and are listed on the major exchanges.

According to Charles Schwab, REITs must pay out 90% of their annual taxable income in dividends. Because of this, they may out a higher rate of dividends than many equities and many fixed income investments, which can create a solid passive income stream. No investment is risk-free, however, and REITs are also known to have highly inconsistent, variable returns, as well as high management fees, so be sure to research the pros and cons before pursuing this investment.

3. Invest in a business.

Providing capital for a privately-held business can generate passive income because your equity stake in the business will earn a share of the profits. Options include funding a startup, investing in a small local business, or investing through crowdsourcing investment platforms such as AngelList, Kickstarter and StartEngine.

There is risk in any business, especially start-ups, so this type of investment is more appropriate to people familiar with taking on this type of investment and understand the nuances of specific business arrangements.

4. Buy dividend-paying stocks.

Dividends represent a payment by a company, typically made on a quarterly basis, to its shareholders from income generated by the business. Investing in stocks that pay dividends can provide a steady income stream.

While this may seem like a no-brainer, it requires a great deal of research. First, you must do all the basic due diligence involved in buying a stock (dividends don’t matter if you select a poor stock and lose principal). Then you must research the history of the dividends paid and the financial environments that lead to stronger dividends.

Many investors prefer purchasing stocks that pay dividends, but it is part of an overall investment plan with dividends being reinvested. That said, you can structure your broader investment plan with dividend paying stocks in order to provide money on hand and treat the principal as your long-term investment.

5. Savings or CD/term accounts.

Placing funds into a savings account, term savings account (similar to a certificate of deposit or “CD”) is a common, safe way to earn passive income. In addition to earning interest, your funds are federally insured up to at least $250,000 if your financial institution is backed by the FDIC or NCUA. While many investors may have given up on interest income after a long period of a near zero interest rate policy by the Federal Reserve, rates have gone up substantially in the last few years.

6. Take advantage of your skills and passions.

If you’re a creative person or simply have an area of expertise or passion, there are many opportunities to use your talent to generate passive income. For example, photographers can license or sell their photographs online via Getty Images, iStock, Shutterstock and other stock photography platforms.

If you’re a tech person, you can create an app to sell on Google Play, Apple App Store, Kongregate and other app marketplaces. While this involves a great deal of work, once built, you have created a passive income stream.

If you have a specific field of expertise, you can develop and publish an online course to teach others how to use a computer program, do auto maintenance, home repairs or build a deck. You are only limited by your imagination. Chances are, you have an area of expertise that would be of value to someone.

You can also generate passive income either through ad revenue or sponsorship by posting content on Patreon, TikTok, YouTube and other social media platforms. Whether it’s travel, gaming, tech gadgets or another interest, sharing your passion and insights through vlogs, product reviews, tutorials and other types of content can build an appreciative audience and earn you extra money.

Tax Implications of Passive Income

Tax liability for active income and passive income are treated differently by the Internal Revenue Service (IRS). Active income is taxed at normal income tax rates and usually taken from your paycheck directly. If you are not a direct employee (say, a contractor or freelancer), and are working off of a W9, you may be required to pay for the portion of your social security liability that would be paid by an employer. Passive income could have a lower or higher tax liability than your active income depending on your venture. Understanding what your tax liability will be is an important part of your due diligence before committing to a passive income project.

Consider the costs and risks.

Passive income may seem like easy money, but it’s not. The costs and risks can be substantial. Before committing to a passive income venture, research and weigh the pros and cons and make a solid plan.

Remember:

Real estate investments can yield profitable returns, but include high upfront investments, management responsibilities, maintenance costs, rental property vacancies, conflicts with tenants, liability issues, legal compliance, tax burdens and fluctuations in interest rates and economic conditions that may reduce income or property values.

Dividends on stock are not guaranteed and investors face stock price volatility.

Attempting to cash in on creative endeavors can be a challenge due to the difficulties in standing out in a crowded, competitive online marketplace, but this could be your best option because your are betting on your own expertise. Just be honest with yourself. The key to earning substantial passive income is to identify an area where you can add value, develop a sound strategic plan and make adjustments when necessary.

Strengthen your financial health with passive income.

You may be feeling a little overwhelmed by all the ways to earn passive income, but you only need to find one that works for you!

Whether you want to have a little more spending money each month, ensure your income keeps pace with inflation, or save funds for a home or car down payment, passive income sources can generate earnings that will provide sustainable financial growth and help you reach your financial goals. Each type of passive income opportunity has a different set of risks and rewards, so be thoughtful and thorough when considering which venture is right for you.

Have you made extra wealth through passive income? Tell us about it in the comments!