A beginner's guide to passive income

Making money without trying might sound too good to be true, but there are smart ways to do it. Unlike the "active" income you earn from, say, your 9-to-5 job, "passive" is a stream of cash that flows without regular work on your part. Examples of passive income include dividends earned from stocks, income from a rental property, or royalties from an e-book you published.

But before you jump in and start buying up apartments to rent or dividend stocks, it's important to understand everything that passive income entails. Some sources are more passive than others, and there are tax implications to consider. Still, passive income can offer an extra boost to your finances, putting you on the path toward financial freedom.

What is passive income?

Passive income is money you make "without a large amount of additional work added to your day-to-day routine," Kiplinger explains. The aim is to generate an additional source of income alongside the money you're bringing in from your job and other places. Doing so can "help you to grow your savings and increase cash flow," Kiplinger adds.

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Is passive income too good to be true?

You might hear some describe passive income as allowing you to earn money while you sleep, but this isn't necessarily true. As Forbes points out, "[m]ost passive income ideas require an initial investment of time, money, or other resources. They also require a degree of monitoring or regular maintenance to keep things on track, but they won't require you to commit tens of hours a week or make small talk at the water cooler."

The amount of time you're sinking into passive income also varies depending on your methods. For instance, opening a high-yield savings account or a certificate of deposit (CD) only takes a bit of research up front (see the table below) and then a bit of time invested in opening the account. On the other hand, real estate investing can be far from passive. As Kiplinger notes, the duties of a landlord take "serious time and effort, and this is just what you can plan for." You might end up dealing with everything from expensive repairs to evictions. And while you could hire a third-party to handle things for you, that will cut into your profits.

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Do you need money to make money through passive income?

Typically you will need what Investopedia refers to as "startup capital" to get your passive income endeavors off the ground. "To develop a meaningful passive income stream from financial assets like cash-equivalents, stocks, and bonds, you'll need a decent account balance," Investopedia says.

There are some passive income streams that require a type of initial investment that isn't necessarily monetary, such as talent or time. For instance, you might not pay much to build an online course that you can then sell repeatedly to form an income stream. However, you will need to invest the time to create a course that people want to buy and have the relevant skills to create that course.

What to know before setting up a passive income stream

You'll want to start by being realistic about how much time, effort, and money you want to sink into your passive income project. As Good Financial Cents highlights, "[t]rying to make more money or create passive income can be a trap because it usually requires you to learn new topics or new skills, and that can be a time suck."

It can be helpful to evaluate your current skill set when determining which passive income stream is appropriate. Do you already have experience with investing? Do you know how to create online content or courses? By zeroing in an area in which you already have some knowledge and experience, you can cut down on the time involved. But regardless of your familiarity with your chosen income stream, you'll likely need to put in some time at the outset to get the ball rolling.

It's also important to realistically assess the risk involved. Some passive income endeavors are riskier than others, and you'll want to ensure you're only taking on as much risk as you're comfortable with. For example, if you create a course that flops, your only loss would be the time it took for you to make it. But if you buy a potential rental property that ends up needing extensive repairs, that presents a much higher level of financial risk.

And last but certainly not least, you'll want to factor taxes into the equation. According to Good Financial Cents, usually "net income from passive income investments is reported as ordinary income," with the exception of capital gains income. In some cases, you might be eligible for certain tax deductions, which could lower the amount you pay in taxes.

4 passive income ideas to consider

Now that you've read up on the basics of passive income, you might start thinking of some ways to earn it. Here are some of the most reliable sources of passive income:

Dividend investments

This can include dividend stocks as well as dividend index funds and exchange-traded funds (ETFs). The latter two might be worth exploring if you don't want to worry about choosing which individual stocks to buy. In either case, you'll get a regular payout of a portion of a company's profits. And according to Nerdwallet, the "best ones increase their payout over time, helping grow future income." However, income is not guaranteed; companies may have to decrease dividends or could become unable to pay them.

To get started, you'll need to open a brokerage account. Also note that "you likely will have to tie up thousands, if not tens or hundreds of thousands, of dollars to earn significant income from dividend stocks," Forbes says.

Bonds and bond index funds

Bonds allow investors to lend money to companies, as opposed to taking an ownership stake like they would when investing in stocks. Investors will then earn interest income.

For those who are more risk-averse, such as individuals approaching retirement, bonds can be a safer bet "because of their lower volatility and relative safety compared to stocks," Nerdwallet explains. However, they'll also "generally earn a lower return on your investment," says Nerdwallet.

High-yield savings accounts or CDs

The trick to making investing in a high-yield CD or savings account a solid stream of passive income is to search for the top rates. Often, you'll find those at online banks as opposed to brick-and-mortar or local banks.

Plus, according to Bankrate, "investing in a CD or savings account is about as safe a return as you can find." The downside of that safety is that returns might not be as impressive. Still, it's better than parking your funds in a bank account that doesn't earn any interest.

REITs

While your initial instinct might be to invest in physical real estate to generate investment income, that can come with a lot of headaches and more time investment than you may want. An alternative way to earn passive income through real estate is by investing in a real estate investment trust (REIT).

As Good Financial Cents explains it, "REITs own and manage income-producing properties and distribute the profits to investors." In some cases, you may need to be an accredited investor, though other platforms make real estate investing more accessible. Nerdwallet recommends that "[n]ew investors may want to stick to publicly traded REITs, which you can purchase through an online broker" or consider diversification through mutual funds or ETFs that track multiple REITs.

Becca Stanek has worked as an editor and writer in the personal finance space since 2017. She has previously served as the managing editor for investing and savings content at LendingTree, an editor at SmartAsset and a staff writer for The Week. This article is in part based on information first published on The Week's sister site, Kiplinger.com

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