When you park your money in a savings account the bank gives you a certain percentage yield on your money – that’s passive income from a savings account. If you invest your money in securities (bonds, stocks, REITs) then you have 2 sources of passive income 1) sale of appreciated funds, 2) dividend yields.
The term passive income refers to the profits that you can get by investing your money and by selling some of the appreciated funds as well pocketing the dividends which flow in either every month or every quarter. There would be some tax liabilities as well, so whatever is left after paying for taxes and fees would be considered a profit.
In the strictest terms, your net passive income is whatever is left over after you deduct your investment fees, taxes, and factor in inflation.
Taxes & Fees
My portfolio is already up by 9% just for this year alone (appreciated funds). I would then also have a 2% dividend income, that’s 11% in total. Since these are passive index funds, I would be taxed at a very low rate. You see, some investment returns are taxed at favorable rates (considered long-term capital gains income) while other investment returns get taxed at the same rate as income (such as what people make when day-trading).
Fortunately, unlike your job-income, you have control over how much money you claim as income from the passive income of your portfolio. This means that you have control over the taxes you will end up paying.
As for fees, my fees are really low. Somewhere in the 0.1% range. Of course, fees can ruin your earnings as well. In 2013 I had a financial adviser who had me invested in mutual funds which had a little over 5% of annual fees – that means that over half of 9% was going towards fees.
Actual Returns From My Portfolio
Assuming 2017 will continue as it is right now, I could have withdrawn about $60,000 this year alone and my underlying investments would have maintained their value. I have a total of $600,000 invested in the securities market, currently.
On the flip side, let’s assume that next year the market goes down by 10%. That doesn’t mean that I would have no income for 2018. I could still get 2% in dividend income but if I were to sell some stocks then my overall balance would drop. And that’s perfectly okay. Most years we expect for passive index funds to be increasing in value. Meaning that even if they drop for a few years, either from market changes or from you selling some of the funds, they would likely recover in the upcoming years.
Why Index Funds Grow In Value
So why do index funds grow in value? Index funds are mutual funds, a specific kind of mutual fund. They are fairly hands-off and have historically returned 8% a year, on average.
On average means that some years it could have gone down by 15% but then recovered maybe by 30% the next year and had 10% gains for a few years, followed by a couple of years of 3% drops, and so on.
The reason index funds grow is because if they didn’t then nobody would invest in them. Yes, it’s exactly that simple, idiotic and circular. Companies need money to operate and money isn’t printed fast enough so they turn to investors. And it’s not just private investors like you or I, plenty of professional asset managers and those who are responsible for multi-billion dollar pensions are investing in these
These public securities companies get to use our money to make a hell of a lot more money and in return they give us a return in form of dividends and appreciation of the fund.
The Term Passive Income
I am still trying to wrap my mind around the term “passive income”. I have realized so far that there is nothing that’s fully passive. You have to put in some sort of ongoing effort or an upfront effort.
The Upfront Work
With index funds, you put in a little bit of upfront effort to choose the right funds that fit your risk profile. Then you figure out how to move money from your account to the brokerage account and that’s pretty much it.
You still have some ongoing work to do. The most important thing is for you to not lose your shit when your portfolio tanks. It’s important to stick to the game plan – your own specific game plan which you need to come up with before you even get into the risk game.
The Ongoing Strategy/Work
Next, you need to pay attention to your ongoing strategy. For most, it means adjusting your asset allocation as your funds swing back and forth in value. This helps you buy low and avoid buying when your funds are priced high.
Another ongoing strategy is to constantly keep adding to your portfolio to take advantage of dollar-cost-averaging.
The final strategy worth discussing is looking for more lucrative passive income returns. This might be adjusting your asset allocation further towards the higher risk (thus, higher return) securities or finding better passive income opportunities.