Passive Income: What is it and why should you care?

You may have heard the term passive income thrown about, but do you know what it truly means?  More importantly, do you understand why you should know all about passive income and why you should be doing whatever it takes to get yours set up today?

We have to look over to our friends at the Department of the Treasury, or the Internal Revenue Service (IRS) for the exact definition.   For some reason, the folks over there just have a way with words, sometimes their definitions and explanations seem to deliberately make things extremely complicated, but here goes.

The Internal Revenue Code, as explained in Publication 925, starts off by explaining that there are actually three different types of income: active income, portfolio income and passive income.  Briefly here is what that means: active income is exactly what it sounds like, money you get from working.  For example, the paycheck you bring home every two weeks is considered active income.  Portfolio income, on the other hand, is also pretty much what it sounds like.  Stocks and bonds in your E-Trade account would fall under the portfolio income category.  Lastly, there is passive income.

Loosely defined, passive income is money you get that you don’t work so hard for, if at all.  According to the IRS, passive income is defined as income received from less than material participation.  Then, they go on for three more pages explaining in minute detail what material participation means.  Never mind all that, here is the Readers Digest version: material participation (or the lack thereof) simply means how involved you are personally in making the money.

Consider this example of passive income; maybe this will help you in “getting” what material participation is all about.  Suppose you own a rental house up in Detroit.  However, you live pretty far away, all the way down on the south side of Chicago.  You pay a management company to find tenants, collect rent and make sure the yard is trimmed; the walk is shoveled in snow season, that kind of thing.  Each month, the management company sends you a check for your rental house earnings less the management company’s expense.  You can see, from your perspective, since you are not actively participating in earning money from your rental house, the money you get will be considered passive income.

So, you now understand what passive income is all about.  Why do you want passive income and why do you want it right now?  Here is a straightforward and easy to understand definition: more money in your wallet.  However, the easy answer hides a significant financial security issue you need to be aware of and take proactive measures against.

Have you seen the news lately?  Have you notice our unemployment rate keeps hovering at an abysmal level?  What would you do if you were suddenly downsized out of your job, your kids were still in school, and you still have another 17 years left to pay on the mortgage?  Oh yes, and of course, your wife is only working part time now because she is eight months pregnant and about to burst.

Or, surely, you have the seen the sad tales on television about older workers who are suddenly “let go”.  Then to their dismay they soon discover the unwelcome news. They are unable to locate any work making money at levels even close to their former income levels if they can find any work at all.  However, if these same workers had been building up a steady passive income over the last few years, at a minimum, it would provide at least a partial safety net.

So, you can see from these two examples, even a small source of passive income can be a life saver. Your passive income source could be the only thing that keeps you going as you look for other work.

Alternatively, let’s suppose you have a steady safe job or a thriving business.  You don’t presently need the additional income to pay bills or anything like that.  In this case, additional passive income sources will allow you to pay off any of your debts earlier, save for your retirement, take an extended vacation this summer and perhaps even retire early.

Go back to the examples above; you can clearly see that passive income is something you seriously want to consider starting today.  Passive income can provide everything from a temporary safety net to an earlier retirement.

So what about you?  Are you excited about the possibility of bringing some passive income into your life?

6 thoughts on “Passive Income: What is it and why should you care?

  1. Nice post. Having passive income is a good thing since it involves less physical participation, if any, in the venture. However, the less involvement the more risk, very generally speaking.
    From a tax perspective, readers may want to know that there is something that federal tax code calls the passive loss limitation rules that prevent taxpayers from offsetting passive losses against other forms of income. That is where the pages and pages of rules and regulations come in to play. They were designed in 1986 to kill tax shelter activity and industry and for the most part it has been successful.

Leave a Reply

Your email address will not be published. Required fields are marked *