At one point or another, you’ve heard the aphorism: “The rich get richer, while the poor get poorer.” But have you ever really stopped to think about why? If this notion holds true, it’s clear that the rich know something that those lower on the net worth totem pole don’t.
But what is it?
The government agency responsible for tax collection and enforcement in the US, the Internal Revenue Service, classifies income into three categories: earned income, portfolio income, and passive income.
We’re all familiar with earned income. In fact, for many, it’s the only form of income we’ve ever experienced. The concept is simple. You go out and find a job that pays you a certain amount per hour or year. Your employer gets a certain amount of work from you, and in return, you receive a steady paycheck.
The problem with this earning method is that there are only so many hours in the day. Trading your time for money, at a maximum of 24 hours in a day, means there is essentially a cap on what you can earn.
Therein lies the beauty of passive income – the ‘secret’ that the rich have been using forever.
Passive income is not dependent on your time. Instead, it is income derived from an asset or activity for which an individual is not actively involved. Two of the more common forms of passive income are real estate and small business.
Imagine that you purchased a rental property for $100,000 using a $25K down payment and financing the rest. Assuming you earn a 7% net return (total return minus insurance, maintenance, property taxes, etc.), your rental income for the year would be $7,000 or $583 per month.
Even if you subtracted the cost of the mortgage payments (approx.: $350 per month), you would still stand to gain over $200 per month from something that is not contingent on the number of hours you’ve worked.
An investment in a small business can work the same way. As an example, let’s say an individual contributes $150,000 into a tire shop so the owner can scale and open more locations. By contributing an agreed upon amount and receiving a percentage of the businesses earnings, the investor is effectively creating a source of passive income.
While this is arrangement is potentially beneficial for both parties, there is a fine line between what constitutes a passive investment and material participation (earned income). According to the IRS, as long as the investor does not participate in the operations in any meaningful way other than placing the investment, the income could be viewed as passive.
If structured correctly, passive income investments will often allow for the most favorable tax treatment. Of course the tax paid on passive income will vary based on the individual’s personal tax bracket, however for illustrative purposes, an average effective tax of 20% would be a reasonable assumption.
Building wealth isn’t done by exhausting all of your energy and resources — something the truly wealthy have known (and practiced) for years. Instead, find ways to generate passive income and you’ll have the ability to create wealth for decades to come. So don’t wait any longer, get started now! Ten years from now you will be glad you did.