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 like 1) Generating $200,000 a year working 4 hours a day or less, 2) Trying to make winning investments, and 3) Keeping 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 5% hurdle, I am not paying down mortgages that cost less than 4%. Debt at 5% 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 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, Motif Investing, 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. You can now learn how to start your own site with my step-by-step guide to save yourself time and money.
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.
* I use Personal Capital to track all my finances in one place. It’s much easier to use their free software to follow 28 accounts on one platform than to log into various accounts to check my balances. They’ve also got great tools for x-raying your portfolio for excessive fees, recommending a more optimized asset allocation, and planning for retirement with their Retirement Planner.
CD Interest Income: My three CDs have been the same for the past several years because they are all 7-year term CDs yielding between 3% to 4.2%. I strongly believe in having 5% – 10% of your net worth in risk free assets such as CDs, cash, or Treasury bonds to keep liquid and have enough fire power to take advantage of buying opportunities. My CD/savings generate ~$20,000 a year in income. They used to generate about $30,000 a year in income until one CD expired in 2014, and I used the money to buy a fixer upper.
Dividend Income: Dividend income is wonderful because it is completely passive and is taxed at only 15% if you are in the 25%, 28%, 33%, and 35% income tax bracket. If you are in the 39.6% income tax bracket because you make over $400,000/year, you will pay a 20% tax on your dividends. My dividend income portfolio mainly consist of dividend equity and bond ETFs such as DVY, VYM, MUB, TLT, and IEF. Total dividend income is roughly $25,000 a year.
Please read The Proper Asset Allocation Of Stocks And Bonds By Age to learn how to best structure your investment portfolio by age. The article goes through the very important “why” so you can invest more confidently for your retirement.
Real Estate: I currently own two rental properties in San Francisco which I bought in 2003 (2/2 condo) and 2005 (4/3.5 SFH), one vacation rental in Squaw Valley, Lake Tahoe (2/2 condo), and my primary residence. Real estate is my favorite asset class to build wealth because it is easy to understand, tangible, provides utility, and rides the way of inflation. I recommend individuals try and get neutral inflation by buying their primary residence as young as possible. The power of inflation is just too hard to counteract.
For example, when I first started renting out my 2/2 SF condo, I was getting $2,200 a month in 2005. Now it is being rented out for $4,200 a month. With rent increasing by just 5% a year, rent is now 91% higher 11 years later! In the meantime, I was able to refinance down my mortgage so that the total payment dropped by about 35%. We are in a goldilocks scenario for real estate investors where interest rates have plummeted, yet rents keep going up. Everybody should either refinance their mortgages right now, or consider leveraging cheap money responsibly to acquire hard assets. LendingTree Mortgage has one of the largest lending networks online, and they will contact you immediately with their offers. You want lenders competing for your business, and get hard quotes so you can pit them against each other.
How To Engineer Your Layoff – In 2012, it took me four months of absolute focus and two years of data to publish my first e-book about helping people negotiate a severance. The book went through over 30 revisions by four people. Then I updated the book for 2016 with 50 more pages (150 pages total) using more successful case studies and highlighting more strategies for those who want to break free with money in their pocket. The book now generates well over $20,000 a year in passive income and has helped numerous people walk away with nice severance packages and healthcare benefits so they can pursue their dreams. I’ve still got one final tranche of severance coming to me in 1Q2017, 5 years after I negotiated my layoff!
Venture Debt – I invested $108,000 in my business school friend’s venture debt fund. He started his own after spending 8 years at one of the largest venture debt funds as a Managing Partner. I’m very focused on income generating assets in this low interest rate environment. The true returns are yet to be seen, as the fund has a 5-7 year life before it returns all its capital.
Real Estate Crowdsourcing – I’m actually very excited about investing money with RealtyShares, one of the largest real estate crowdsourcing companies based right here in San Francisco. RealtyShares allows investors to invest in large commercial or residential projects you wouldn’t be able to purchase yourself with as little as $5,000. Further, they’ve got different investment opportunities all over the country. I plan to invest in Midwest and Southern properties with higher capitalization rates compared to expensive SF, NYC, LA, and Miami.
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. My goal is to generate $200,000 a year in passive income because I believe that is the optimal income level for maximum happiness. You aren’t taxed to the extreme and you still benefit from deductions without too much AMT. Further, $200,000 is enough to live practically anywhere in the world and feel comfortable.
I’ve currently got a $25,000 a year passive income deficiency. I plan to do the following:
Allocate CD Income to Real Estate Crowdsourcing: A large $340,000 CD yielding 4% is coming due in 1Q2017. It generates ~$13,600 a year. I plan to invest $100,000 with RealtyShares for a target 9% – 11% return ($9,000 – $11,000), $160,000 in tax-free California municipal bonds yielding ~3% ($4,800 a year, equivalent to $7,000 gross), and the remaining $80,000 in a Treasury Bond ETF like TLT yielding 2.5% ($2,000). The total income should therefore be around $17,000 – $19,000 a year for an extra $3,400 – $5,400 annual income.
Continue To Raise Rent & Refinance: I plan to raise rent by 5% total, which should lead to an extra $5,000 a year in annual income. At the same time, I plan to continue refinancing my mortgages whenever I see at least a 0.5% better rate with no points and minimal closing costs. Everybody needs to refinance their mortgage if they haven’t done so in the past 6 – 12 months. Shop around. You will be surprised. Refinancing should free up another $2,000 – $3,000 a year.
Book/Product Sales: I plan to be more aggressive in marketing my book by doing more podcast interviews and writing more guest posts. I’ve also raised the price by 50% to test out the elasticity of demand. The best thing about having your own site is that you have a platform that can be leveraged. Everybody should have their own website to brand themselves online at least. I’ve received countless bonus consulting opportunities as a result of FS. I see $10,000+ a year in upside with my book.
So far, I’ve come up with a realistic way to generate roughly $20,000 a year in additional passive income I can work on for the next year.
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: $1,100 for a two-session FS Consulting package or $600 for one, 1.15 hour session. I spend at least one hour preparing before the call and another hour typing up my notes and providing an action plan for execution after the call. 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 3,800 word post has taken around eight hours to write with a dozen revisions. 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. That said, I enjoy blogging so much.
It’s been seven years since I started Financial Samurai and I’m actually earning a good income stream online now. Financial Samurai has given me a purpose in early retirement. And, I’m having a ton of fun running this site as well! Here’s a real snapshot of a personal finance blogger who makes $150,000+ a year from his site and another $180,000 from various consulting opportunities due to his site.
PLAN AND START ALREADY
“He who fails to plan is planning to fail.” Winston Churchill
Building passive income takes a long time. The key is to create a plan, save as much as possible, and just get going. Start investing in assets where you are most comfortable. Always start small and work your way up. Also consider creating your own income producing products. Technology and the internet have tremendously lowered the cost of starting your own site and reaching millions of people.
Do something long enough and good things will happen. All the best in your passive income journey!
Track Your Finances
One of the best ways to build wealth is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts on their Dashboard so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 28 different accounts (brokerage, multiple banks, 401K, etc) to track my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing, how my net worth is progressing, and where my spending is going.
One of their best tools is the 401K Fee Analyzer which has helped me save over $1,700 in annual portfolio fees I had no idea I was paying. You just click on the Investment Tab and run your portfolio through their fee analyzer with one click of the button.
They also launched an incredible Retirement Planning Calculator that pulls in real data from your linked accounts to run a Monte Carlo simulation model to output the most likely results of your financial future. I strongly suggest you run your own numbers, play around with the income and expense variables, and see how you stack up. It’s all free and easy to use.
Updated for 2017 and beyond.