The easiest way to gain financial independence is to reconfigure your life so that a substantial portion of your income is not actively earned by your labor. Instead, it must come from passive income.
The basic idea of passive income is that it is money received with little or no effort required to maintain the flow of income once the initial work has been done. Some common examples of passive income are:
- Rent from real estate properties
- Patent royalties for an invention
- Trademark licensing fees for characters or brands you’ve created
- Royalties from books, songs, publications, or other original works
- Profits from businesses in which you have little or no day-to-day role or responsibility
- Earnings from Internet advertisements in a blog or on a website you own
- Dividends from stocks, REITs, equity mutual funds, or other equity securities
- Interest from owning bonds, certificates of deposit, other cash and cash equivalents
- Residual income for a sales person on accounts that are typically renewed automatically such as a sporting goods representative that earns a commission on his accounts, bringing in a few thousand dollars per store per year for servicing the customers once they have been opened
Why You Should Prefer Passive Income to Active Income
Passive income is attractive because it frees you to spend your time on the things you actually enjoy. A highly successful doctor, lawyer, or publicist, for instance, cannot “inventory” their profits in the words of one well known author. If they want to earn the same amount of money and enjoy the same lifestyle next year (the year after that), they must continue to work the same number of hours at the same pay rate. Although such a career can provide a fantastic life, it requires far too much sacrifice unless you truly enjoy the daily grind of your chosen profession. Even worse, once you desire to retire, or find yourself unable to work any longer, your income will cease to exist unless you have some form of passive income. In the past, this was accomplished by employee participation in company-sponsored pension plans.
Taxes and Passive Income
A major advantage of earning passive income is that it is often taxed more favorably than active income. That may seem unfair, but the idea is that it will give people an incentive to invest in assets that will grow the economy and create jobs.
A business owner that works in his company, for instance, would have to pay an extra e.g 15.3% in self-employment payroll taxes compare to someone who merely had a passive interest in the same limited liability company who would pay only income taxes. In other words, the same income earned actively would be taxed at a higher rate than if it were earned passively.
If lower taxes and control over your time aren’t incentive to prefer passive income over active income, I don’t know what is.