Earned vs. Passive Income

Most people make money by trading their time for a salary. You work 40 hours a week, and your employer gives you a paycheck a couple of times each month. It’s a pretty simple deal. You come in and work, and you get paid. Stop coming into work, and you stop getting paid. This is called earned income. The amount you get paid is directly related to the amount that you work. (There are always some exceptions to this rule. For instance, vacation and paid leave allow you to not work and still get paid, but the rule still stands. If you stop going into work, you will stop getting paid.)

Passive income (or its cousin, residual income) is different from earned income in that it doesn’t require you to trade your time directly for money. Passive income is generated by systems that earn money constantly, regardless of whether you are working on that system or not.

When most people first hear about passive income, a lot of these terms don’t really make sense. “What exactly do you mean by a “system”? “How does it earn me money when I’m not working on it?” Let’s take a deeper look at some passive income systems and exactly how they generate income.

Passive Income Systems

A passive income system is simply any business, job, or property (physical, intellectual or otherwise) that continues to produce income for you even when you are not working on it. Here are some examples.

Investments – Probably the most “pure” example of passive income is having a large amount of money invested in the stock market, and living off of the interest generated by your investments. This leaves the principal free to be reinvested, generate more income, and the cycle repeats itself. Unfortunately, this option needs large sums of money to make it work, so unless you are already independently wealthy this is not really an option.

Owning a Business – Owning a business can be a great source of passive income. Hire a manager to take care of the day-to-day operations, and your business will generate income even when you’re not there to run it. You can even start a franchise – such as a fast food restaurant, shipping store or janitorial service – and you won’t have to come up with the basic idea or business plan by yourself.

Rental Properties – Have you ever rented a house or apartment? Did you notice how your rent was due every month, regardless of how often you saw the landlord? That sounds suspiciously like passive income. If you own the property, your tenants pay their rent on a regular basis, whether you are there working on the house or not.

Running a Website – Running/owning a website or blog is another great source of passive income. Once you have a decent amount of traffic coming in, there are several methods of monetizing the site: putting up advertisements, charging for content, selling a product, etc. The point being, readers/users are still coming to the site even when you’re asleep, thereby helping you make money.

The common factor in all of these systems is that your time is not tied together with the amount you get paid. This is unfortunate at the beginning because you’ll be working long hours for very little pay. But after while, if you keep at it, your income will start to increase. At some point your income will be roughly approximate to what you would expect to get paid in a similar salaried position. At that time you can decide whether to invest more of your time into your business to increase your salary even higher, or whether you want to lower your hours to spend time on other projects.

Maintenance

There’s one other thing to mention on this topic and that is the maintenance you’ll need to do on these systems. No matter what sort of system you set up or how well it’s done, you’ll always have to spend some amount of time maintaining the system to keep it going. If you have several million dollars in the stock market, you (or your financial advisor) will have to keep an eye on how your investments are doing to make sure you’re still making money. If you own rental houses and you never maintain them, before too long the roofs are going to be full of holes, the gardens will be full of weeds and you won’t be able to find anyone to rent them from you.

Don’t confuse maintenance with being tied to the clock like a real job. You still get to choose when to work on your business(es), you get to choose whether to do the work yourself or pay someone else to do it, you get to decide what needs to be done about problems that arise, etc. You’re still in charge.

So what other passive income systems are there? I always love hearing about how other people are using some creativity to make money. Let me know in the comments if I’ve missed any.

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This is Part Two in my series on passive income. Check out the other parts below.

1) All Income Is Not Equal
2) Using Passive Income Systems To Make Money

While making money as an employee is a good option for many people, most of us (including myself) never made a conscious decision to make money from employment. We just fell into it by default. And that’s the problem. If you’ve never evaluated the benefits and risks of being an employee and compared them to the risks and benefits of other ways to make money, then you may have set yourself up for some avoidable displeasure.

In this post, we’ll begin to step back and take a fair look at employment. First we’ll discuss the basics of the system and then we’ll look at some pros and cons of employment. We’re also going to introduce some criteria that we’ll use to evaluate any income system, whether it’s being an employee, making money online, or investing your money. The criteria we use to evaluate income systems are as follows: The Asset – what exactly it is that is making money in this system; The Cash Inflows – specifically how income is received from this system; The Taxes – how the system and the income it generates are taxed; The Cash Outflows – the expenses and debts created by the system; and lastly, System Control – who exactly controls and runs the system.

Looking at these criteria allow us to systematically examine any method of making money and determine what the pros and cons of that system are. Let’s now take a look at employment as a system for making money.

The Asset:

All systems of making money fall into one of two categories:

1)trading the use of an asset for money, or
2)creating or adding value to an asset that you then sell.

Employment falls into the former category since you are the asset that is being traded for money.

Think about that for a minute. Does that seem a bit Orwellian to you? “You are the asset that is being traded for money.” If you strip away all of the emotional and human aspects of your job and just look at it from a financial standpoint, that’s exactly what is happening. Or, if we want to be more specific, your time is the asset being traded for money. You go to work, give eight hours of your life to your boss, and he or she pays you a salary. If you stop giving him your time, he stops giving you his money.

The Cash Inflows:

Typically an employee agrees to perform specified tasks or meet certain goals in exchange for cash pay and non-cash benefits. Wages are generally received on a weekly, biweekly or semi-monthly schedule. Benefits may include paid vacation, paid sick-days, subsidized health and life insurance, and training.

The Taxes:

Wages from employment are generally subject to federal, state, and local income taxes as well as payroll taxes (FICA and Medicare). These taxes are withheld from each paycheck so there is minimal opportunity for tax planning or tax deferral. This is important to note since taxes on wages are generally higher than on other forms of income.

For example, if I were making $400,000 a year (I’m not yet) then I would pay tax at the following rates:

Federal: 35% of taxable income
State: 5% of taxable income
County: 1% of gross wages
City: 0.5% of gross wages
Payroll: 7.65 of gross wages

That’s a total of 49.15%. So for every additional dollar earned I only get to keep 51 cents. However, if that additional dollar of income came from a rental property then I could keep 60 cents. And if the additional dollar came from a capital investment in a business then I could keep 80 cents.

Cash Outflows

Working as an employee also causes you to incur expenses. You will probably have automobile expenses due to a commute, and could possibly even need to purchase an additional vehicle. On top of that, additional costs for clothing, medical treatments, food, and insurance should be expected.

System Control

When you work as an employee, the system that is generating your money (the business that you work for) is going to be owned and controlled by one of several people – it might be your boss, it might be a group of partners (such as a law firm) or, in a large company, it might be the shareholders. The important thing to note here is that in all of these situations, the system is not controlled by you. You will generally have little to no say in the operation of the business, the clients it takes, or how much money it makes.

This is part one of our look at employment as a system to make money. Hopefully this has helped you think about having a typical job in a new light. In our next post, we’ll examine employment further and see when it’s a good idea to have a job and when it’s not such a good idea.