Why Passive Income Beats Active Income
Most doctors and other high-income earners only focus on (and know about) active income. They buy their “stuff” with active income such as cars, boats, watches and suits.
Active income is the MOST heavily taxed income there is.
Read that sentence again and let that sink it.
Related article: 5 Smart Ways On How To Reduce Taxable Income For High Earners
Why keep working hard, paying the highest amount of taxes possible when you can work smarter?
The goal is to get your passive income to match, at some point in your career, your active income and that’s what we’re going to be talking about today….exactly how to do it.
3 Types Of Income
Let’s discuss the basics when it comes to earning money.
There are only three types of income
- active (earned) income
- passive income
- portfolio income
#1 Active income
Active or “earned” income is the most familiar to us as it’s what we make while we work at our jobs. It is also the highest taxed of the three income types. Unfortunately, we focus all of our efforts on earning this type of income which causes us to pay the highest amount of tax.
If you earn active income ONLY, you’re trading your time for money.
#2 Passive income
Passive income is income derived from a rental property, limited partnership or other enterprise in which he or she is not actively involved.
Passive income from real estate is not subject to high effective tax rates. Why? It’s typically sheltered by depreciation which results in a lower effective tax rate compared to earned income.
#3 Portfolio income
Portfolio income is generated from dividends, interest, and capital gains from selling stocks.
Education Doesn’t Prepare Us
Unfortunately our education system doesn’t prepare us financially. It ONLY focuses on earning active income.
They teach us how to work and trade our time for money. Again, this type of income is the MOST highly taxed.
For example, Dr. G graduates dental school and gets out making $200,000 a year in a large group practice. He’s so excited and tells his family that he’s making $16,000 a month and doesn’t have to live off hamburger helper anymore!
Little does he know that he’s getting ready to only focus on work that trades his time for money. If they give him $16,000 a month, then the government is going to take 40% of that money. Uncle Sam is going to get his share no matter what.
In Dr. G’s case, $6,400 comes off his $16,000 a month leaving him with $9,600 a month. Unfortunately, most people don’t even know what their taxes are.
If he was earning $16,000 a month in all passive income, only $3200 would be paid in taxes so he’d end up with $12,800. Which would you rather have?
Most people have never been taught about active income and taxes. I know I wasn’t.
I borrowed money to go to dental school and a residency program. Guess what? Nobody there ever taught me the difference between passive and active income.
You Still Need Active Income
Now, you can’t just go out and make passive income today. You need the active income first. Some people out there tell us that we only have to work four hours a week and that’s it.
I don’t know about you but I haven’t found any of those people yet. I myself have to work more than four hours a week if I want to keep this household chugging along.
I don’t think anybody should have a goal to only work four hours a week. We need workers. People need to work as it gives them a purpose.
Even if I had more money than I knew what to do with it, you’d still see me working (sitting on my mower or coaching kid’s sports).
The goal is to have both active income and passive income.
During my fourth year of dental school, we had a course called “Professional Development.” Occasionally we had local dentists/physicians come in and talk about how to run a practice or the latest techniques they were using to treat patients.
Some of the speakers were salespeople pitching their products or services such as insurance or financial advice. I actually fell for one of the disability insurance pitches while still in school. The guy told us that if we didn’t buy then, our premiums would more than double when we graduated.
This is a perfect example of why we try to avoid salespeople when we get out. They prey on our limited knowledge.
One guy was a financial planner that did a good job of laying out investing advice with regards to retirement plans. He focused on active income only and gave different scenarios of how compound interest would cause our money to grow after we worked for 30-40 years (what if we did NOT want to work that long??).
For most of us, this is the only financial advice we know about… work our entire lives, invest our money, hopefully have enough saved to retire and never run out.
He nor anyone else ever mentioned passive income, specifically real estate passive income. If you want to someday experience financial freedom, then you must have passive income coming in.
Related article: How Much Money Is Enough? – It May Be Less Than You Think
I love the mailbox money that the syndication deals are paying us each year.
I still want to be paid for seeing patients but it’s really nice getting a check whether I show up or not. Having passive income streams will allow you to travel and not have to worry about the office being shut down with the overhead still churning.
If you want to go to Europe or a cruise, great. With passive income, you can choose how to spend your time.
If you’re married, I encourage you to sit down with your spouse and ask them, “How do we get passive income?” Get them onboard as two people working on this are better than one.
One way this could be accomplished is via the stock market. For example, you could go buy AT&T stock. Ten years ago it was trading around $42 a share.
Today as I write this article, it’s $38 a share. You would have lost $4, but here’s what you would have earned, a 6% dividend.
Let’s say you put $10,000 in it. This would have created passive income. You took the money from your active income, then after you paid Uncle Sam, you invested $10,000 ten years ago.
Even though the stock went down, you still were paid a 6% dividend.
Let’s do the math: 6% on $10,000 is $600 for 10 years.
You would have been paid $600 each year or $150 every quarter. This is what’s called a dividend. This is passive income.
Even though the stock went down, watch what happened. The dividend, the passive portion of the investment, paid you back $6,000 out of your $10,000 ($600 x 10 years).
Now, if you sell it today, you’re going to be selling it for a third less than you paid for it or roughly $7,000. But the fact is you don’t really care about the loss. You paid $10,000 but it’s only worth $7,000 today. You really don’t care about the loss because you made the loss when you bought it.
What does that mean, Jeff? Glad you asked.
You took $10,000 and you gave it to an institution. It bought a piece of paper that was locked away that stated you own $10,000 for the AT&T stock. During this time, hopefully you had your fingers crossed that everything was going to be all right and it would continue paying you a dividend.
But in this case, it paid back $6,000 over a ten year period. You lost your money when you bought the paper, when you bought the AT&T stock.
Real Estate Passive Income
You’re probably like most of us that have always relied on active income to invest in things that continue to go up and down. The AT&T stock is a perfect example.
What you want to do is to stop buying things that go down or up. You want to start buying things that stay stable and pay you a big dividend with the hope of a big upswing to it.
If you make $200,000 a year, what your goal should be is, “I need to match that with $200,000 worth of passive income. I want them both.” Ultimately, what you want is more passive income than active income.
Are you concerned about leaving a legacy or taking care of your spouse and kids when you die? Passive income keeps coming in even after you pass on.
Passive Income Ingredients
Now that you know that you can’t continue to rely on your active income, here’s a few key ingredients to passive income:
- Focus on matching your active income with passive income
- Invest in things that don’t go down in value such as real assets, not a piece of paper.
- Only invest in companies that can’t be disrupted.
Why did the AT&T stock go from $42 to $38? Because it’s in telecom and it’s being disrupted.
At some point, Facebook will be disrupted. Trust me. YouTube will be disrupted. Google will be disrupted overtime. Apple will be disrupted.
Is the rotary phone your mom used to use still around? Nope. It was disrupted.
How To Think About Money
He suggests we get out into the real world and bust our butts to make as much money as possible in order to invest it and make it work for you.
I like this model but would also like to add, if you’re in debt, pay it off as aggressively as possible at the same time. I prefer the Dave Ramsey Debt Snowball method.
You should be able to do both with your GREAT income!
Take your money, park it over on the side and when you find the right asset, buy it. Whenever I’m ready to make a purchase, I use the passive income to buy it.
I’m now more laser focused on investing in assets that do two things:
- Will go up over time
- Will pay me without me having to be there
It’s time to get on the smart side of investing. Invest in things that can’t go down in value and that pay you whether you show up to work or not.
Real Estate Investing For Passive Income
Whether you realize it or not, everybody is an investor. People are constantly investing their time and energy and exchanging it for money.
If you treat a patient and their insurance company pays you $150, you’ve invested your time in exchange for that money. That’s an investment.
What you have to learn is how to invest your money so that it continues making money so that you don’t have to invest your time for it to grow.
There’s too many doctors that I talk to on a weekly basis that have piles of cash that they’re sitting on. When I ask them about that, they tell me that it’s for a “rainy day.”
I live in Louisiana and it rains all the time. Cash money is going down in value. If you think saving it will get you somewhere, it won’t. Unless you enjoy your money not growing.
Get rid of the money and buy hard assets. If you’re just starting out in your career, invest in yourself. You’ll never lose it as nobody can take away your intelligence.
If you read a book and learn a new skill or about a new investment such as multifamily syndications, no one can take that knowledge from you.
A few years ago, I started educating myself about how to make real estate passive income via crowdfunding. I won some and lost a big one but what I learned along the way, it can’t be taken from me.
If you want to stop trading your time for money then you’ve got to get out of playing the active game. The active income game that is. I want you to go all in playing the passive game.
Invest in yourself, focus on growing your active income and begin putting money on the side. Once it grows then buy assets that are going to go up in value and start paying you passive money on a routine basis.
Do you know what holds most people back from doing this? FEAR. That’s right, fear. Any book on being successful or any person that’s made it will tell you the same thing.
It starts with a mindset shift. It takes courage to deplete your cash reserves and put it in something such as real estate.
It’s up to you. You’ve got to make a choice.
Do you continue to let your money sit in a bank and die or not?
Are you an accredited investor and ready to begin replacing your active income with passive?
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