How To Build Passive Income For Financial Independence
Creating genuine passive income is the holy grail of personal finance. Not all passive income is created equal mind you. Some streams take much more initial effort to start, such as saving enough to buy your first rental property. But once you start it’s very difficult not to gain momentum.
Everything passive first takes active energy. The time to put in the effort is when we are young and not ravaged by disease or burdened by family obligations. I remember being able to snowboard from 9am until 4pm every day for a year. Now, I’m lucky to last from 11am until 2pm without wanting to go to the hot tub and drink a bucket full of beer! If we can appreciate how lucky we are when we are young, we’ll be able to maximize our vitality and live financially freer when we are older.
With sustainable passive income you can do the following:
* Retire early and travel the world.
* Start a business in a field you are passionate about.
* Find a job that pays less, but is more interesting.
* Stay at home to take care of your family without having to worry about money.
* Volunteer for causes you truly care about.
* Be a big brother or big sister.
* Spend more time with your parents.
* Sit in a coffee shop on a 80 degree day in Paris for hours on a Wednesday afternoon.
* Write the next great novel on the balcony of a cruise in the Mediterranean.
* Eat tapas and drink sangria until 1am on a Monday evening.
* Potentially live longer due to much less stress.
* Experience perfect endless summers over and over again.
There is so much you can do once you generate enough passive income to pay for all your living expenses. I highly encourage everyone to at least try. This post will provide you the framework for passive income success. I’ll also provide an update on my estimated 2013-2014 passive income streams which have grown since retiring in 2012.
THE PASSIVE INCOME FRAMEWORK
1) Save Like Nobody Owes You Anything. Passive income starts with savings. Without a healthy amount of savings, nothing works. Your overall “Money Strength” will be an F- if you do not build a financial nut. In our current low interest rate environment, you must save even more than before. It’s important to also realize that the savings I am referring to is AFTER-tax savings. You need to save money after contributing to your 401k and IRAs since you can’t touch pre-tax retirement accounts without a penalty until 59.5. Ideally everyone should max out their pre-tax retirement funds first, but if you don’t have enough funds and want to retire earlier then a decision to have more accessible post tax money will still work.
What I did: Saved 50-75% of my after tax, after 401K contribution every year for 13 years because I knew I could not last in finance for more than 20 years. Now I am saving 100% of my passive income as I try and bootstrap my online businesses.
2) Find Out What You Are Good At. Everybody is good at something, be it investing, playing an instrument, playing a sport, communications, writing, art, dance and so forth. You should also list several things that interest you most. If you can combine your interest plus expertise, you should be able to monetize your skills. A tennis player can teach tennis for $65 an hour. A writer can pen her first novel. A finance buff can invest in stocks. A singer can record his first song. The more interests and skills you have, the higher chance you can create something that can provide passive income down the road.
What I’m doing: I love to write and invest. Combine these two interests with my ability to get things done equates to multiple investment types and this personal finance site. I understand why some writers go crazy. There’s so much information in my head that I need to write it down or else I might explode.
3) Create A Plan. Mark Spitz once said, “If you fail to prepare, you’re prepared to fail.” You must create a system where you are saving X amount of money every month, investing Y amount every month, and working on Z project until completion. Things will be slow going at first, but once you save a little bit of money you will start to build momentum. Eventually you will find synergies between your work, your hobbies, and your skills which will translate into viable income streams.
What I’m doing: I use this site to write out goals 1) Generate $200,000 a year working 4 hours a day or less, 2) Predict the future to try and make winning investments, and 3) Keep track of my passive income streams. My site and the community helps keep me accountable for progress. It’s important I do what I say, otherwise, what the hell is the point? You should consider starting a site or at least a private journal. Write out your specific goals, tell several close friends and stick to the plan.
4) Treat Passive Income Like A Game. The only real way to begin your multiple passive income journey is when you are making active income. The initial funding has to come from somewhere. Hence, treat passive income as a game that has various levels. If you fail to achieve one level, it’s not the end of the world since you still have active income and can restart. Furthermore, a game is meant to be played with integrity. Using shortcuts (non passive income streams), someone else’s income as a supplement (spouse), or one-offs (capital gains) does not count. The primary purpose of any game is to bring enjoyment to the player and beat the boss.
What I’m doing: I view passive income as funny money to keep myself sane during this long journey. I estimate 2-10 years to get to my goal depending on how active I am. The dollars created are just points one can accumulate. I’ve made passive income goals for each passive income type and check in at least once a year like I am now to make sure I’m on track. Passive income is also carefully managed to minimize tax liability. When you can build a buffer for a buffer, you are then free to take more risks.
5) Determine What Income Level Will Make You Happy. Think back to when you made little to no income as a student. Now think back to the days when you just got started in your career. Were you happy then? Now go over every single year you got a raise or made more money doing something else. How did your happiness change at all, if any? Everybody has a different level of income that will bring maximum happiness due to different desires, needs, and living arrangements. It’s up to you to find out your optimum income level.
What I did: I first identified my favorite places in the world to live: San Francisco, Honolulu, Paris, Amsterdam, New York City, and Lake Tahoe. I then looked up the median rent and housing prices for each city. Then I factored in private education costs for two kids to be conservative given I may not have two kids and public schools are often good enough. After calculating all vital costs, I then did a self-assessment of how happy I was making $50,000, $100,000, $150,000, $200,000, $250,000, $350,000, $500,000, and $750,000. I decided working 20 hours a week making $200,000 a year is the best income balance for maximum happiness.
6) Always Remember That Everything Is Relative. The best way to determine worthwhile passive income streams is by comparing the likely return (IRR) with the current risk-free rate of return. If I round up, the 10 year bond yield is at 3%. Any new venture should thoroughly beat 3% otherwise you are wasting your efforts since you can earn 3% doing nothing.
What I’m doing: My realistic goal is to have a blended annual return of 2x the risk free rate. With a current 6% hurdle, I am not paying down mortgages that cost less than 5%. Debt at 6% is a wash. My realistic blue sky scenario is a 3-4X rate of return over the risk free rate which can be achieved with property, stocks so far for the past five years, and certain private equity investments. Where I am dragging is my blended average CD interest rate of roughly 3.75%. It’s guaranteed money, but one of my biggest goals is figuring out how to reinvest this large nut starting in the next two years.
7) Never Ever Withdraw From Your Financial Nut. The biggest downfall I see from people looking to build passive income is that they withdraw from their financial nut too soon. There’s somehow always an emergency which eats away at the positive effects of compounding returns. Make sure your money is invested and not just sitting in your savings account. The harder to access your money, the better. Make it your mission to always contribute X amount every month and consistently increase the savings amount by a percentage or several until it hurts. Pause for a month or two and then keep going. You’ll be amazed how much you can save. You just won’t know because you’ve likely never tested savings limits to the max.
What I Do: I’ve set up multiple investment accounts outside my main operations bank that deals with working capital e.g checking, paying bills. By transferring my money to Fidelity, E*Trade, and two other banks as soon as it hits my main bank I no longer have temptation to spend on frivolous things. As a result, I can wake up 10 years later and reap the rewards of compounding. My 401(k) is the best example where constant contributions over 13 years has grown to almost half a million without any savings pain given it just became a part of life. Real estate is also a fantastic asset class for the long term. The transaction costs make trading inefficient. Sooner or later, your financial nut will grow large enough that it spits out difference making income. Once you get to that level you will be more inclined to save more. It’s like finally seeing results in the mirror after working out. There’s no going back to flab.
8) You Must Force Yourself To Start. “A Journey Of A Thousand Miles Begins With A Single Step.” Laozi was a great philosopher who penned this popular English translation. Everything great started somewhere and you must set aside one day to tackle your financial independence goal. Circle the date on your calendar and cancel all other distractions. Although starting is most difficult, once you do the inertia of your efforts help carry you forward. If you understand Chinese, his exact words are: 千里之行﹐始於足下 (Qian li zhi xing, shi yu zu xia). Action arises from stillness.
What I did:The first two years of work in NYC was brutal. I told myself there was no way I could work on Wall St for my entire career because I’d probably die from heart failure by age 40. Having an early death in my mind willed me to save 50%+ from the first year onward and devise a CD, real estate, and stock investment distribution system for my savings every year. I thought about starting this site for at least a year before I hired someone from Craigslist to give set me up and push me forward. Hiring someone to get started is totally worth it if you are a master procrastinator. Failure is a part of life. I’d rather fail a hundred times and learn from my mistakes than never try at all. Whenever I’m fearful of trying something new, I remember back to my youth when I did not ask a girl out or when I didn’t try out for the varsity basketball team. These two things might sound silly to you, but to me, I use them as reminders to stop being chicken shit. Embarrassment, failure, and loss of money is much better than regret.
PASSIVE INCOME SNAPSHOT
The below is my latest estimated passive income streams. I consider interest, dividends, rental income, and royalties as the only passive income streams.
* Now you know why I love Personal Capital. It’s much easier to use their free software to track my accounts than check every single account one by one and update my balances. Furthermore, what you see here is only my passive income statement. I’ve got the entire net worth statement to manage with a total of 28 line items such as: primary residence, watch collection, baseball collection, ancient coin collection, Moose, private real estate, private equity, and business. Letting online software keep track of my assets is so much easier.
CD Interest Income: The reason why there are so many CDs is because I’m a rate seeker. Banks are always offering different promotions and it’s up to us to move our capital accordingly. My six CDs have been the same for the past several years because they are all 7-year term CDs yielding between 3% to 4.2%. The last one was taken out two years ago. Every year the CD portfolio grows by over $30,000 meaning I get an additional $1,000+ in interest income a year due to compounding. I plan to only renew my CDs if I can find a 7-year yielding CD for 3% or higher. Capital One 360 with no fees has an interesting savings program with an APR of about 0.75%. I like how I can fund excess liquidity by just linking my checking account.
Dividend Income: The S&P 500 grew another ~20% while dividend payout ratios held steady or increased. As a result, my like-for-like dividend income has also grown by around 20%. The financial sector gained roughly 28% in 2012 which is especially good since I have a lot of deferred stock in my old financial firm. I think dividend income will continue to grow given public companies have record cash on their balance sheets. They need to either mobilize their cash through investments, or return cash to shareholders in the form of a buyback or dividend payout increase.
I invested a large chunk of change in several structured notes in the summer of 2012. The yield to maturities range from two years all the way up to six years. The structured notes are a way to play the upswing in the stock markets while providing downside protection. For example, a large investment was in a Dow Jones structured note at 12,400 that provides 100% downside protection, 115% participation (15% outperformance kicker), but only a 0.5% dividend yield vs. a market dividend yield of around 2%. I’m happy to give up 1.5% in dividends per annum for six years to ensure my money will be there when the note expires.
Finally, I still believe for those who are in the earlier stages of their investment careers to focus more on growth stocks vs. dividend stocks. It’s all about building a large enough capital base so you can generate large enough dividend income. If you’re a 30 year old and buying Walmart and Coca Cola, you’ll probably do OK in the long run, but you aren’t going to see huge outsized growth because these companies are already quite mature. My main goal in investing is capital appreciation and not dividend income at this stage.
Real Estate: This is where things got really good and why I continue to love real estate. I was able to get a free loan modification for one of my vacation properties out of the blue in January 2013 that lowered my payment by $670 a month. Meanwhile, HOA expenses declined by $80 a month, yielding $9,000 a year / $750 a month in extra cash flow. The other good news is that rents have gone up by roughly 5% on this specific property. I also raised my main rental property’s rent by 11% and my other rental property’s rent by 4%. If you have not checked the latest mortgage rates online in the past six months, take a look at Quicken Loans. I check that site like a hawk for real quotes based on my financials once a quarter. The numbers you see in the sheet are after all operating costs and property taxes.
Other: It took me four months of absolute focus and two years of data to publish my first e-book, How To Engineer Your Layoff: Make A Small Fortune By Saying Goodbye last summer. The book went through over 30 revisions by four people. The second half of 2012 was my testing period to get feedback from readers and fix any mistakes. The distribution channel is only here and through a couple affiliates. For the next 12 months, I plan to reach out to at least 10 new relevant sites to write guest posts or do book reviews. Income should continue to grow given there is no other book out there that teaches you how to profitably quit your job by negotiating a severance package. For those of you who write good content in the Career or Lifestyle categories, I encourage you to sign up and become an affiliate via e-Junkie.
In the fourth quarter of 2012, I also started investing with Prosper.com. I’m starting slow given I’ve got a year before my first CD rolls off. I look forward to generating realistic 5-8% returns vs. their advertised 9%+ returns. If I can gain the confidence in putting my entire CD allocation into P2P lending, such passive income could double to over $60,000 a year.
MAKING UP FOR THE DEFICIENCY
Hopefully my passive income chart provides you with a good snapshot of how various passive income streams can really add up over time. As part of the passive income framework section, I set out a goal to make $200,000 a year working four hours a day by December, 2015. In twelve months, I was able to grow my passive income stream from ~$80,000 to ~$110,000.
Part of why the goal is $200,000 is because $200K used to be the income threshold where the federal income tax rate would increase to 36%-39.6%. Add on 10% California state tax and other taxes and I’d be paying over 50% of every non dividend dollar I earned to the government. No thank you! Thankfully, Washington DC compromised with a $400,000 income threshold. $200,000 a year should be enough to comfortably live anywhere in the world.
Despite the passive income increase, there is roughly a $7,400 a month / $90,000 a year passive income deficiency. Below are some thoughts on how to achieve my goals.
Allocate CD Income To P2P Lending: P2P lending returns should be able to return 5-7% in a relatively low risk way. Take a look at the various interest returns by credit score and borrower rating in this post. I’m comfortable starting off with $10,000-$20,000, but I don’t have the guts to invest hundreds of thousands of dollars yet. However, if I study P2P lending over the next two years, perhaps I will have the confidence to at least lob $250,000. The $250,000 would see a roughly $8,500 incremental annual income increase if I could get 7%. You can open an account here with Prosper.com. I recommend starting off with $2,500 and 100 notes average $25 a note for diversification. Build your portfolio as you gain more confidence.
Continue To Raise Rent & Refinance: Real estate truly is my favorite investment asset class. Unfortunately interest rates have ramped higher by 1% from its 2012 lows so I probably won’t be refinancing for a while. San Francisco rents grew by 15% in 2012 and I expect them to grow by at least 7% in 2013 and another 7% in 2014 due to the surge in internet/technology business. Such rental increases will lead to $5,000 a year in additional income. Meanwhile, my mortgage interest payments continue to go down by an estimated $42,000 a year as principal gets paid down, leading to a total positive swing of $7,000-$8,000 a year in profits. Put it another way, if I can pay off all my mortgages I will generate an incremental $42,000 a year in cash flow. If inflation picks up, then the figures should go much higher.
Book/Product Sales: I’m happy to sell 30-40 books a month at $48, but I’ve been thinking about raising the price since I think it provides so much value. How much would you pay to gain back your freedom and walk away with thousands, if not tens of thousands of dollars and do what you’ve always wanted to do? To me, freedom is priceless. But of course I’m biased about how good my book is and should also consider decreasing the price to see if there is elasticity of demand. I will continue to build up relevant articles about career development, severance packages, entrepreneurship, and so forth. I can see book sales double off this low base due to an increased effort in marketing, leading to an additional $18,000 a year in passive income. Maybe I’ll even write another book!
Municipal Bonds: I’ve been fearful of municipal bond funds for a while given what’s going on in Europe. Thankfully, muni bond funds have now gotten hammered thanks to a drastic rise in interest rates. I’m going to spend a good amount of time researching any laggard muni bond funds with tax free yields of 4% or greater. If I can allocate a third of my CD money in munis, I might should be able to easily beat a 4% gross return (2.8% net at a 30% tax rate) since muni bonds are tax free and regularly yield over 4%. Muni bonds could generate an incremental $5,000 a year, however, I could also easily lose principal value.
So far, I’ve come up with a realistic way to generate roughly $33,500 – $38,500 a year in additional passive income in two years. Unfortunately, I’m still $55,000 short of my $200,000 a year passive income goal! I’d like to continue keeping my estimates conservative in nature because it’s better to end up with too much than too little.
WHAT ABOUT OTHER INCOME STREAMS?
As part of the Passive Income Framework section, we are playing the game with integrity. It’s no fun beating the Big Boss with a cheat code or super weapon that annihilates all enemies with one click of a button. The goal is to develop income streams that keep rolling in if we do nothing at all!
Income streams that don’t count:
* Capital gains: Unless you can repeatedly sell stock for profit, capital gains is a one off item. It’s just as easy to lose money in the markets as it is to make money, so stop pretending like you are Warren Buffet.
* Freelance writing: Quality freelance writing takes tremendous effort. Ironically, the better the quality of your writing, the more you don’t want to freelance and just keep the articles for your own site. Freelancing is a great way to earn side income, however, it’s not really for me. I’ll probably take on one or two freelance jobs maximum per year and write no more than four articles a month elsewhere.
* Financial Consulting: $1,250 for the FS Steele Package requires hours of preparation before the three calls and hours of preparation after the call to make sure there is follow through. Furthermore, a client gets five comprehensive e-mail consultations in between sessions which takes time as well. Consulting is very rewarding because there’s nothing better than helping someone understand things. It just takes a lot of preparation because I want to give the best, most tailored advice to my clients as possible.
* Selling anything: If I decide to one day sell my Roberto Clemente rookie card for $800, I’m not going to include this in my passive income streams because I’ve only got a couple of them. Same thing goes for selling a watch or electronic device.
* Blogging: This 4,259 word post has taken around eight hours to write with a dozen revisions just while I’ve been in Mexico alone! Content does not magically appear out of thin air as some might believe. It takes a tremendous amount of effort, consistency, and creativity to come up with helpful and interesting content. The only people who really appreciate how much it takes to be a blogger is another blogger, not even a freelancer. We’ve got to take pictures, edit, market, build a brand, guest post, and network. Compare this with our journalist friends at any other major media publication who get to write assignments, submit and be done with.
It’s easy to get lazy if we do not compartmentalize our income streams. We must be honest with our income streams so our income can be honest with ourselves.
PLAN AND START ALREADY
“He who fails to plan is planning to fail.” Winston Churchill
If I didn’t have a plan, I wouldn’t know what passive income level to shoot for nor would I have a clear idea of what I need to create or where I need to optimize. With all my accounts tracked in one place, I know exactly what I must do to achieve my goals. It’s taken me 14 years to get to my current passive income stream. As a result, it may be somewhat optimistic to double my passive income in just two and a half years. That doesn’t mean I’m not going to try because it’s much easier to make money once you’ve built that financial nut.
It’s important to avoid the temptation of spending your nut while you’re young and full of hope. It’s like eating your golden goose for short-term pleasure. I promise you that 10 years from now you will be absolutely grateful for the financial steps you take today.
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