How To Build Passive Income In Order To Retire Early

Anything passive first takes active energy. The best time to put in the effort is when you are young and not yet ravaged by disease or burdened by family obligations. If you want to learn how to build passive income in order to retire early, you've come to the right place.

In 2012, at the age of 34, I built $80,000 worth of passive income to retire from my day job in finance. Today, I'm using my passive income to take care of my wife and young children.

Our passive income has grown to about $300,000 a year, partially thanks to a bull market and our investments in real estate crowdfunding.

With sustainable passive income you can:

  • Live a longer life due to significantly less stress.
  • Launch a business you are passionate about.
  • Spend extra time visiting your parents.
  • Find a job that may pay less, but is more fun.
  • Stay at home to care for your family without money stress.
  • Volunteer for causes you believe in.
  • Be a mentor or coach to disadvantaged youth.
  • Experience endless vacations over and over again.
  • Lounge in a coffee shop on a 76 degree day in Santorini for hours on a Monday afternoon.
  • Eat tapas and drink sangria in Barcelona until 2am on a Wednesday evening.
  • Look and feel better thanks to less stress.

This post will provide you with the framework for passive income success to retire early. If you can work on building passive income for at least 10 years, I'm certain you'll be able to taste more sweet freedom. 

How To Build Passive Income To Retire Early

If you want to reach FIRE (Financial Independence Retire Early), follow this 7 step framework

1) Save Until It Hurts Each Month.

Passive income is much more valuable than you realize. And it all starts with savings. 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 and want to retire earlier, then a decision to have more accessible post-tax money will also work.

What I did: Saved 50-75% of my after-tax, after-401K contribution every year for 13 years. I knew I could not last in finance for more than 20 years and wanted to have an escape hatch. 

Now, I live 100% on 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. 

2) Identify Your Unique Skillset

Each of us is good at something. Perhaps it's investing, music, sports, singing, writing, art, dance or whatever. The more interests and skills you have, the higher the chances are that you can create something that will provide you with passive income down the road.

Due to the internet, one of the absolute best ways to build passive income is by creating an electronic product like an e-book, an online course, an app, or even a song.

What I'm doing: Writing and investing are my passions. These two interests led me to start Financial Samurai, my personal finance site, in 2009. Although writing isn't passive, Financial Samurai gives me a platform to earn income passively through my severance negotiation book.

3) Formulate A Plan.

There's a great quote by Mark Spitz that says, “If you fail to prepare, you're prepared to fail.” Put together a system where you are saving X amount of money every month, investing Y amount every month, and working on Z project until completion. 

Don't be discouraged if things start off slow. Once you start to save money you can build momentum. Eventually, synergies will emerge between your work, hobbies, and skills that can turn 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 financial tools online. I don't want to wake up 10 years from now wondering where all my money went. The internet is your friend. 

4) Determine Your Passive Income's Purpose. 

You need to have passive income goals. 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 each month and so forth. Calculate your overall basic expenses necessary for survival. Once you have those expenses covered, you are golden.

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 recalculated that we would need to earn if my wife were to join me in retirement. Today, we continue to set new goals of generating passive income to support our family of four.

5) Figure Out Which Type Of Passive Income Suits You Best.

The best way to determine worthwhile passive income streams is by understanding their risk, return, feasibility, liquidity, and maintenance activity.

You must always compare the expected return to the risk-free rate of return, which is the 10-year government bond yield. Any new venture should thoroughly beat it. Otherwise, you are likely wasting your efforts.

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.

My realistic goal is to have a blended annual return of 2x the risk-free rate, or ~6%. To sustain my passive income goals, I will need to accumulate roughly $3.3 million in capital. However, given I've got to pay taxes, I'll probably need closer to $4 million in capital to live off passive income and never touch principal.

If I decide to move from San Francisco to the heartland, however, perhaps I can live off $80,000 a year in passive income and accumulate $1.3 – $1.5 million of capital instead. Having passive income allows you to geo-arbitrage.  

Best Passive Income Investments For Retirement

See: Ranking The Best Passive Income Investments

6) Never Withdraw From Your Financial Nut.

The most frequent setback for 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.

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. 

Real estate is also a fantastic asset class for the long term. The illiquidity of real estate and the transaction costs encourages you to hold for the long term. 

7) You Must Force Yourself To Start.

Laozi was a famous philosopher who penned the popular English saying, “A Journey Of A Thousand Miles Begins With A Single Step.” Take the initiative to set and achieve your financial independence goals. Mark a date on your calendar and remove all other distractions.

What I did: My first two years of work in NYC were exhausting. I knew it wouldn't be healthy for me to work on Wall St for my entire career. The stress was too intense.

Having an early death on my mind motivated me to not only save 50%+ from the first year onward, but to also devise a CD, real estate, and stock investment distribution system for my savings every year.

My original target retirement date was 2017 at age 40. Instead, I left five years earlier in 2012 at age 34 largely because long-term planning had yielded more income and opportunity.

Real Estate Crowdsourcing Is My Favorite Passive Income Source

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.

My SF rental had a cap rate of ~2.4% versus cap rates of 10%+ in heartland real estate where I've reinvested. With the SALT deduction capped at $10,000 and a lower mortgage maximum of $750,000 to be able to deduct mortgage interest against, I expect coastal city real estate to slow and heartland real estate to outperform. I'm targeting a 15% IRR on my investments.

My favorite real estate crowdfunding platform is Fundrise. They started in 2012 and have the best technology and selection of eREITs. Their platform portfolio of funds have consistently outperformed the stock market during difficult times.

For specific real estate crowdfunding deals, my favorite platform is CrowdStreet. There are a lot more opportunities with more attractive valuations and potential return profiles now that there are lockdowns. CrowdStreet focuses on 18-hour cities, where valuations are lower, cap rates are higher, and potential growth is also higher.

Financial Samurai Real Estate Crowdfunding Dashboard

Plan And Get Started Already

Building passive income takes a long time. Always start small and work your way up.

Consider creating your own income producing products that require little-to-no startup capital. I never knew that one day, a book about how to negotiate a severance would generate more passive income than the rental income from a $1,200,000 property. There is a reason why we worked so hard on our creativity as kids.

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. Earning passive income can provide you with the opportunity to retire early and more. Making progress and having more choices leads to greater happiness.

All the best on your passive income journey!

Recommendation To Build Wealth

Manage Your Money In One Place: Sign up for Personal Capital, the web’s #1 free wealth management tool to get a better handle on your finances. It's an incredible resource to take advantage of to grow your wealth and build passive income to retire early.

In addition to better money oversight, run your investments through their award-winning Investment Checkup tool to see exactly how much you are paying in fees. I was paying $1,700 a year in fees I had no idea I was paying.

After you link all your accounts, use their Retirement Planning calculator that pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms. Definitely run your numbers to see how you’re doing. I’ve been using Personal Capital since 2012 and have seen my net worth skyrocket during this time thanks to better money management.

Personal Capital Retirement Planner Tool

If you enjoyed this article, How To Build Passive Income In Order To Retire Early, access more nuanced personal finance content and join 60,000+ others and sign up for the free Financial Samurai newsletter. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009. I help people get rich and live the lifestyles they want.