What Is Passive Income? A Complete Guide

Earning passive income means that with some planning and initial legwork, you can earn money without actively working. That’s not to say you don’t have to work at all — though some kinds of passive income could help you make money while you’re sleeping or on vacation. Rather, you’re frontloading your time and, after the initial setup, will work much less to maintain this type of income source.

Let’s explore several of these revenue streams and how they could get you closer to financial freedom.

What Does Passive Income Mean?

The IRS defines passive income as revenue from a business or rental company that won’t require your active participation. You can extend passive income to involve money earned with minimal involvement from the person who created the income stream. Unlike active income, you don’t have to spend hours each day at a full-time job or other type of job where you need to be present to generate funds.

How Does Passive Income Work?

Passive income is a way to earn steady revenue without actively working for it. Passive income streams may take time and effort upfront to launch, but once they’re up and running, you’ll benefit from the extra funds without a huge, continued time commitment, which can come from rental properties, affiliate marketing and more.

While some passive income sources might need a larger initial investment of time or money than others, there are many that don’t. For example, conceptualizing a course and selling it can take a lot of upfront time in terms of building trust with an audience, marketing, creating and selling your offerings. Real estate may not take as much time, but you may need a lot of upfront capital in order to purchase a property, flip a home, or invest in a project.

Once the initial effort is put forth to establish your passive income stream, it usually only requires small amounts of occasional maintenance. Using the examples above, maintenance work could involve updating your course material every few months or working with your property manager to ensure that your home and tenants are happy.

Can Passive Income Be Taxed?

Yes, most forms of passive income count as taxable income. However, the IRS treats various kinds of income sources differently. Plus how much you’re taxed will depend on several factors such as the income source. For instance, if you held onto investments in the stock market for more than 12 months, the earnings or income may be classified as a long-term capital gain and is usually taxed at a lower rate than ordinary income. However, if you sold investments you held onto for less than a year, they may be taxed at a higher rate. Same goes for income you earn through selling a course, or even if you earn rental income from your properties.

Other ways you could be taxed depend on the amount you made per year and how much you can legally deduct as business expenses — like ones to run your online or real estate business. Since all this can get complicated, it’s best to speak with a tax specialist or financial advisor to determine what you may owe in taxes.

Common Passive Income Ideas That Require Capital

The following are eight of the most common passive income ideas that will require upfront capital.

Invest In A Rental Property

Real estate investing is one of the best ways to generate passive income, and there are many different ways to do so through rental properties. A popular way is to purchase an investment property and rent it out long- or short-term to others.

However, don’t underestimate the commitment of becoming a landlord. It can require a high initial investment of your time and money – and there’s nothing passive about getting a call in the middle of the night because there is something wrong with the property. Rental properties also take significant upkeep, and some repairs are expensive. Consider paying a property manager so you can collect passive income without doing too much yourself. If you choose this route, just remember you may earn less in profits.

Purchase Real Estate Investment Trusts

A real estate investment trusts, or REIT, is another way to invest in real estate that doesn’t require as much upfront work as buying your own place. Instead, you’re investing in a group of real estate assets through a financial institution, such as a brokerage or a real estate crowdfunding platform. You’ll own shares of commercial properties such as office buildings, apartments, or malls in the same way you’d own shares of a company’s stock. After your upfront investment, REITs typically pay out regular monthly or quarterly dividends to account holders.

While a REIT is a great way to invest in real estate without having to manage it yourself, it can come with some downsides: the dividends you earn count as regular or ordinary income, you may have to pay high fees, and you may be subject to market fluctuations.

Invest In Dividend Stocks

Dividend stocks allow you to buy and sell index funds or shares of a particular company. Besides any appreciation that you'll earn from selling for more than your purchase price, these stocks also issue quarterly or annual payments. The company takes part of its earnings and sends them to investors each year in the form of a dividend. How much you earn will depend on how the company fares year to year.

Invest In Bonds And Bond Funds

Bonds and bond funds are utilized by companies or the government when they’re looking to raise money. You as the investor are essentially lending these entities money, and receiving interest back. It’s a great way to generate passive income – all you’re doing is lending money and earning revenue without having to do much else. Options to purchase bonds include through the U.S. government (such as treasury bonds) or via a brokerage.

Open A High-Yield Savings or Money Market Account

A high-yield savings account offers a much higher interest rate than what you’d typically find with a regular savings account. A money market account is also a type of savings account. Although neither account will generate high returns compared to some of the other options, you can earn some money instead of letting it sit there in a savings account. It can be a great way to maximize your savings in your emergency fund, for example.

Certificate Of Deposit

A certificate of deposit, or CD, is a time-bound savings account that offers a guaranteed rate of interest for a certain amount of time. Once your CD’s term is up (or when it matures), you’ll earn the guaranteed amount of interest and have your principal balance returned to you. It can be a great way to ensure you won’t lose money on the principal, especially if you’re investing for a short-term goal. However, rates may not be as high as other investment options.

Peer-To-Peer Lending

Peer-to-peer (P2P) lending involves individuals lending and borrowing money from each other through a more formal method. The idea is to bypass the banks and use P2P lending platforms, helping borrowers increase their chances of being approved for a loan, and for investors to earn a good rate of return.

There are many reputable platforms to use to lend out money, though your returns will vary depending on the platform and loan. As with any investment, there is a significant amount of risk involved in P2P lending. Many borrowers who go to P2P platforms for a loan may have little or poor credit, so there’s a chance of default if the borrower stops making payments. This means that you won’t get your money back if the loan defaults. Thoroughly research the platforms you’re considering before investing.

Ways To Create Passive Income Streams With Little To No Capital

There are many ways to create streams of income that don’t require upfront capital. Some options include selling a digital product, renting out a room in your home, and affiliate marketing.

Rent Out A Room In Your Home

Airbnb and other short-term rental platforms have become ubiquitous over the past several years, and more and more homeowners are using them to rent out their home. Many visitors check out Airbnb listings to help them save money instead of staying at a hotel. Why not capitalize on this trend, and earn money from your existing property?

You can rent out a room even if you’re not going out of town. Earning some money is better than earning none at all.

Sell Courses Online

If you have a special skill, there’s probably someone who will pay to learn it. Producing an online course allows you to create your product once and then earn money through multiple sales without necessarily requiring your active participation.

It may take some time to create a course and build an audience that is willing to buy from you. Consider other features that could help you sell it, such as an accompanying e-book, downloadable worksheets, or additional videos.

Sell A Digital Product

Selling a digital product instead of a course could be less time-intensive and could offer you a chance to dip your toes into online business.

Different types of digital products you can sell include:

• E-books
• Audiobooks
• Stock photos
• Music

Try Affiliate Marketing

Affiliate marketing helps you earn a commission each time you successfully refer another person to a company’s products or service. You can directly suggest your recommended products or services to people. Or you can have an online platform such as a social media account or a website to point readers to affiliate links.

To get started with affiliate marketing, all you need to do is to sign up for a unique link with the company proving you’re the one making the referral. There are also affiliate marketing platforms where you can apply to become an affiliate with many brands, usually grouped by industry. Any money you earn will then be paid out, typically on a monthly basis or when your account hits a certain threshold.

The Bottom Line

Passive income, like any investment, requires thinking beyond the short term. If you’re patient and continue to be consistent, you can create multiple passive income sources and generate multiple income streams.

Whether you want to use passive income to supplement your cash flow or to entirely replace your full-time job, consider how you can layer multiple strategies and build a cascade of revenue streams that will earn you money day and night. For additional insight on your finances and to keep track of any income from passive income streams, sign up for Rocket Money℠ — it’s free.