Developing passive income is the key to obtaining financial freedom. Everyone should come up with a passive income strategy once they know how much passive income will make them happy.
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 to kids in need.
- Spend more time with your parents.
- Sit in a coffee shop on a 76 degree day in Santorini for hours on a Monday afternoon.
- Write the next great novel from the balcony of a cruise in the Mediterranean.
- Eat tapas and drink sangria in Barcelona until 1am on a Monday evening.
- Live longer due to much less stress.
- Look and feel better due to much less stress.
- Experience perfect endless summers over and over again.
This post will teach you how to build passive income and have more financial freedom. I worked on building passive income for 13 years until I was able to negotiate a severance at the age of 34 in 2012 and be free forever.
The Passive Income Framework
1) Save until it’s painful each month.
Without a healthy amount of savings, nothing works. You need to save at least 20% 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 first max out their pre-tax retirement funds. However, if you don’t have enough funds to do that and still want to retire earlier, then concentrating more of your money in after-tax investments may be preferable.
Please take a look at the savings guidance chart below if you would like to retire early and have financial freedom. For example, if you save 50% of your after-tax income for 17 years right out of college starting at age 23, you should be able to retire at around 40 years old.
With 17 years worth of living expenses, you can last until 57 before you completely run out of money. But since you will be earning a risk-free rate of return of at least 3% during your 34 years, you should easily be able to make it until Social Security kicks in.
Savings Is Key
To understand this better, let’s look at some numbers. If your disposable income is $100,000 a year after taxes, saving 50% means living off $50,000 and putting away $50,000. After 18 years, you will have saved $900,000. Given you were living off $50,000 a year, by definition, you have 18 years of living expenses before running out of money at age 58.
But given you can earn 3% risk-free a year by buying a 10-year treasury bond, you will have actually accumulated at least $1,200,000 after 18 years. At a 5% rate of return, you will have accumulated $1,476,000.
And at a 7% rate of return, you will have a handsome $1,819,000. With $1,476,000 – $1,819,000 in capital at the age of 40, you can earn $44,280 – $54,570 in gross passive income assuming just a 3% rate of return. Therefore, you shouldn’t ever run out of money, especially after Social Security kicks in.
What I did: From 1999 – 2012, I saved 50-80% of my after-tax, after-401K contribution every year because I had a goal of leaving finance by 40. However, at the age of 34, I decided to negotiate a severance because I had already saved over 30 years of living expenses.
The severance gave me an additional six years worth of living expenses, which made leaving my well-paying job that much easier. Today I live 100% off my passive income and reinvest 100% of any income I make online or from part-time gigs like coaching high school tennis to build even more passive income. Financial freedom is priceless.
2) Determine Which Type Of Passive Income Suits You Best.
Earning a 3% risk-free rate of return is the minimum return expectation because it is guaranteed if you buy a 10-year government bond yield. In reality, you should be taking more risk when you’re in your 20s and 30s to try and achieve a higher rate of return. Time and energy are on your side.
According to market history, we know that a 100% bond allocation has a historical annual return of 5.6% between 1926 – 2016. Meanwhile, a 100% stock allocation has a historical annual return of roughly 10%, including dividends. You must decide how much public investment risk you want to take based on your financial needs and risk tolerance.
Beyond public stocks and bonds, there are other asset classes that provide passive income such as private equity, venture debt, P2P lending, real estate crowdfunding, and creating your own online products. The best way to determine worthwhile passive income streams for financial freedom is by understanding their risk, return, feasibility, liquidity, and maintenance activity.
What I’m doing: I’ve accumulated 10 different passive income sources based on my interests and for the sake of diversity. However, I plan to reduce exposure to private equity and P2P lending once these investments come due.
I think private equity valuations are too high and P2P lending returns are becoming less compelling. My favorite passive income source for financial freedom was physical real estate in my 20s and 30s, but now that I’m in my 40s, I’m focused more passive real estate investments now.
3) Determine Your Passive Income’s Purpose.
You need to have passive income goals if you want financial freedom. Otherwise, it’s easy to lose focus and give up.
A good first goal is to earn enough passive income to pay for food each month. A second goal could be to earn enough passive income to pay for transportation, and then rent and so forth. Calculate your overall basic expenses necessary for survival. Once you have those expenses covered, you are free to take more risks.
What I did: Based on years of budgeting, I determined that $80,000 a year in San Francisco would be enough for me to live a comfortable retirement life. After leaving work, I calculated that we would need to earn $150,000 if my wife were to join me in retirement. Today, we have a goal of consistently generating at least $200,000 a year in passive income in order to also provide for our son.
If we decide to move from San Francisco to the heartland, where everything is cheaper, perhaps my family can live an equally great quality of life with half that amount. Once you’re able to generate enough passive income for financial freedom, there’s no need to live in an expensive, congested city anymore.
4) Keep Yourself Accountable.
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 may be slow going at first, but once you start to save a little bit of money you will build momentum. Eventually, you will find synergies between your work, your hobbies, and your skills that will translate into viable income streams.
What I’m doing: I use Financial Samurai to write out goals and to keep myself accountable. I also keep track of my net worth and all 10 of my passive income investments with free online financial tools.
I don’t want to wake up 10 years from now wondering where all my money went. When it comes to their personal finances, too many people go through life just winging it. Given there is no rewind button, you must stay on top of your finances and watch them like a hawk.
5) Never Withdraw From Your Financial Nut.
The most frequent setback for people looking to build passive income is that they withdraw funds from their financial accounts 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.
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 a couple brokerage accounts and two other banks as soon as it hits my main bank account, I avoid the temptation to spend on frivolous things.
Investments such as venture debt and physical real estate are less liquid than stocks and bonds and therefore may help you to invest for the long run. When the financial world was falling apart between 2008-2010, It was too difficult and too costly to sell my properties. Therefore, I just held on and collected rent. But with stocks, it was much more tempting and easier to bail.
Passive Income Snapshot
Below is an example of my estimated passive income streams. My goal is to keep my passive income above $250,000 so that my wife and I will have enough to pay for our son and daughter’s grade school education if they can’t get into their local public school in San Francisco.
Online Savings ($6,960/year):
I’m actively trying to build a large cash stash given we’ve had such a strong bull run since 2010. Further, given higher interest rates, it no longer feels like a sin to keep cash in a money market account earning 0.1%.
Dividend Income ($26,400):
Dividend income is wonderful because it is completely passive and is taxed at only 15% if you are in the 10%, 12%, 22%, 24%, 32%, and even 35% federal income tax bracket. If you are in the 37% income tax bracket you will pay a 20% tax on your dividends. My dividend income portfolio consists mainly of dividend equity and bond ETFs.
Municipal Bond Income ($33,600):
I own a portfolio of individual California municipal bonds that I plan to hold until maturity and several bond ETFs. Although the Fed is raising rates, I don’t believe long-term rates will rise much higher. In other words, I expect the yield curve to flatten or invert more by 2021. In such a scenario, fixed income investments should outperform equities.
Real Estate ($59,040):
I currently own one rental property in San Francisco which I bought in 2003 (2/2 condo), one vacation rental in Squaw Valley, Lake Tahoe (2/2 condo), a panoramic ocean view single family home, and my primary residence. My rental income can have 25% swings depending on how good the weather is in Lake Tahoe during the winter.
Online Book Sales ($50,400):
I published How To Engineer Your Layoff in 2012, six months after I had negotiated my own severance. Then I updated the book for 2018 with 50 more pages (150 pages total) using more successful case studies and highlighting more strategies for those who want to break free from the corporate grind with money in their pocket.
Venture Debt ($19,200):
I invested $200,000 in my business school friend’s second venture debt fund. The target IRR is anywhere from 12% – 18% a year over the next 5 – 10 years. Therefore, I’m hopefully being conservative as the returns are back-end weighted.
Real Estate Crowdsourcing ($69,600):
After selling my SF rental house in mid-2017 to simplify life and take advantage of high valuations, I proceeded to reinvest $550,000 of the proceeds ($810,000 total) in real estate crowdfunding to take advantage of lower rates and higher net rental yields in the heartland of America.
With the SALT deduction capped at $10,000 and a lower mortgage amount maximum of $750,000 to deduct mortgage interest against, I expect coastal city real estate to slow and heartland real estate to outperform.
Below is my real estate crowdfunding dashboard where I’ve invested $810,000 since 2016 and am starting to receive a large sum back in 2020+.
Plan And Get Started Already
“A journey of a thousand miles begins with a single step.” – Laozi
Your goal is to build enough passive income so that by the time something inside you vigorously wants a change, you’ll have the financial means to make it happen.
All the best on your passive income journey to financial freedom!
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About the Author: Sam began investing his own money ever since he opened an online brokerage account in 1995. Sam loved investing so much that he decided to make a career out of investing. He spent the next 13 years after college working at leading financial service firms in the world. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate.
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