Investing for Passive Income: What to Know

Traditionally, income is earned by trading your time or effort to an employer for money. However, it’s possible to gain additional income passively by investing smartly and strategically. This can help supplement what you may already make from your current job, allowing you to save and invest more for your future.

In this article, we’ll discuss investing to create passive income. That includes an overview of the types of assets that can provide a source of revenue. You’ll also learn about the benefits and risks of investing to create additional income. Finally, we’ll explain how a financial advisor can help you get on the right track.

What Is Passive Income?

Passive income refers to a type of income that flows in without having to be earned through a job or contract. Generally, this comes from a person’s investments in several different types of assets, such as stocks, mutual funds, or real estate. Like regular income, passive income is taxable.

The term, “passive,” can be a bit of a misnomer, however. While it implies that you don’t need to earn or work for the additional money, you still must invest your time and money to build these sources. For instance, if you were to invest in a rental property to generate additional monthly revenue, you still need to buy the home, do potential renovations, and seek a tenant.

It’s common for individuals to invest in such a way that their portfolio generates regular passive income for them. While this may not entirely make up a person’s investment strategy, it serves as a way to add additional income to fuel the growth of one’s portfolio or savings.

Assets That Provide Passive Income

Many types of assets can allow you to receive passive income from your portfolio. In some cases, it’s as simple as parking your money in an account or buying shares of a stock. Other investments require more legwork on your part to create a reliable source of income, such as real estate. Be aware, however, that income isn’t always a guarantee and there’s always a risk you’ll lose some or all of your principal investment.

Stocks

One way to receive passive income is by investing in dividend-yielding stocks. Many companies distribute a proportionate amount of earnings to shareholders. These payments, which are often quarterly, can be an effective way to create supplementary income.

Be aware, however, that dividends from stocks are taxable as either ordinary income or capital gains. Qualified dividends, which are from common stocks you’ve held for at least 60 days, incur a capital gains tax rate of 0%, 15%, or 20%. Unqualified dividends, on the other hand, are taxed at your typical rate.

Bonds

Bonds, or fixed-income securities, are another potential source of passive income you can invest in. After buying a bond, it’ll mature over a particular period, paying you back your initial capital, plus interest.

While bonds carry relatively minimal risk, be aware that if an issuer runs into financial trouble, you could lose your investment. However, bonds typically have a rating assigned by Moody’s, Standard and Poor’s, and Fitch. This allows you to measure the risk and quality of a bond before you buy one.

Mutual Funds

Like with stocks, mutual funds can generate passive income for you. These are professionally managed portfolios that you can buy shares of. Many allow you to earn dividends as a shareholder, giving you a source of passive income.

Keep in mind that dividends for mutual funds require you to pay capital gains tax if they’re qualified. Additionally, if you sell shares for a profit, you must pay taxes on your earnings.

Real Estate

A common method to earn passive income is by investing in real estate. Particularly, buying properties for the sake of renting them out can result in a reliable and potentially substantial monthly cash flow. This does, however, require significant work and capital to put in place.

Alternatively, you may also invest in real estate investment trusts (REITs) as a means to both add real estate to your portfolio and earn passive income. These are companies that buy, sell, and operate properties to generate consistent income. Much like stocks, REITs pay dividends to shareholders based on the earnings their properties supply.

Certificates of Deposit (CDs)

CDs are a simple, yet effective way to earn passive income over a set period. These allow you to place your funds in an account at a high interest rate for several months or years. The only catch is that you must wait out the entire term to withdraw your money.

While CDs are relatively low risk, it’s important to consider that once you put that money in the account, you won’t be able to touch it until the term is up. This illiquidity can be inconvenient if you end up needing the funds down the road. Before investing in a CD, be sure to speak with a professional to ensure you aren’t disrupting other areas of your finances by putting that money away.

High-Yield Savings Accounts

Another option to earn passive income is by using a high-yield savings or money market account. These arrangements allow your money to gain interest over time based on how much you have in the account.

As an example, imagine that you placed $20,000 in a money market account at an interest rate of 5.3% APY. After five years, you’ll have gained $5,892.37. While this may not be a gigantic return, it’s still an effective way to earn additional cash while your money sits in place.

Benefits and Risks of Investing for Passive Income

Earning passive income from your investments provides many benefits, including more financial stability and room to save and invest more. However, you should also consider the risks before jumping in. For instance, volatile market conditions and the initial investment can be significant hurdles to cross for many investors.

Below is a breakdown of the benefits and risks to consider:

How a Financial Advisor Can Help

Building a portfolio that’s able to generate supplementary income can take much work, especially at the beginning. Besides that, market conditions can be volatile, which can expose you to risk as you invest. For these reasons, it’s wise to sit down with a financial advisor and ensure you optimize your portfolio for your needs.

In your meeting with an expert, they’ll likely want to understand your goals, risk tolerance, and time horizon. Additionally, they’ll determine how much you have to invest. These details will inform what types of assets are most likely to help you. An advisor should also be able to identify potential risks and work with you to avoid them as you begin to invest.

If you need help finding a high-quality financial advisor, we recommend using this free matching tool. After answering a few questions about your current situation and goals, it’ll connect you with a professional that’s tailored to your needs.

Frequently Asked Questions

How is passive income taxed?

Most passive income requires you to pay either portfolio or passive income taxes to the federal government and, if applicable, your state. In these cases, you don’t need to pay Social Security or Medicare taxes. Other sources, such as from qualified dividends or when you sell a security for a profit, will need you to pay capital gains tax, however.

Does passive income count as capital gains?

Passive income from selling a security for a profit or from qualified dividends qualify as capital gains. This requires you to pay capital gains tax at a rate of 0%, 15%, or 20%.

Is being a landlord a source of passive income?

The income you earn from rental properties is passive. However, while passive, it does require a significant level of effort, research, and capital to begin.