Passive Income and Your Financial Plan
Last month, we covered the “Buzz around passive income.” This month, we will examine how passive income strategies can help you reach your goals. We’ll also examine potential landmines around passive income strategies that can make it a less attractive investment.
WHAT IS PASSIVE INCOME
First, let's revisit the concept of passive income. Passive income investments generate income without requiring constant effort or attention. This can take the form of purchasing a percentage of an apartment complex managed by a professional management company or owning bonds that pay periodic coupon payments, typically twice a year. Now that we've refreshed our understanding of passive income let's delve into the factors that can integrate it into a strategic plan to help you achieve your financial objectives.
Passive income presents an opportunity to diversify your income sources. For clients whose income fluctuates due to bonuses, commissions, or the nature of their industry, the idea of a stable income stream can be appealing. It's akin to having a financial safety net that helps smooth out the peaks and valleys of certain job types. Investors who have portfolios concentrated in investments that do not pay much in the way of dividends may also consider income-producing investments. (Think technology companies…)
NEARING RETIREMENT WITH PASSIVE INCOME
Households a few years away from retirement might want to consider incorporating these types of investments into their portfolios. By doing so, pre-retirement households can start building a foundation of passive income, essentially setting the stage for a reliable income stream once they bid farewell to their careers. It's like strategically planting financial seeds today to reap the rewards of a secure income in retirement.
IT’S NOT ALWAYS A GOOD FIT
These are a few examples where passive income is additive to your financial situation. Let’s turn the table and see where it may not be a good fit. High-income households should clearly understand how income-generating investments will impact their taxes. These households in the upper end of the current 24% tax bracket and higher should strongly consider how adding more income will affect their taxes. A higher passive income may look significantly less attractive once you realize that it bumps you into a higher tax bracket, or you could have found other investments that would have produced a higher after-tax return. A lot of real estate investments are touted as tax-efficient investments. Don’t be fooled; much of the tax efficiency in real estate investing comes from buying and selling the properties and is not necessarily tax efficient from an INCOME standpoint. Some depreciation deductions and pass-through deductions can reduce some of the taxes due on the income you’ll receive. Still, a lot of real estate tax efficiency comes from ACTIVELY owning real estate (which is the opposite of passive investing.)
STAYING TRUE TO YOUR FINANCIAL PLAN
Passive income investments like real estate often sound like a cool investment alternative. A diversified portfolio of stocks, ETFs, and bond mutual funds can feel a little pedestrian. You want to invest in something exotic, like a warehouse in Des Moines, because owning more Apple or Berkshire Hathaway isn’t that exciting. However, it's important to remember that investment decisions should be guided by your financial goals, not just the desire for bragging rights amongst your buddies. That’s what fantasy football is for.
THE HARD TRUTH
The siren song about passive income is all about reliable income with no work. There are trade-offs on many investments that offer income streams. Income streams are expected to be reliable, but they are not guaranteed. Real estate investments can have tenant turnover, which can reduce or even eliminate distributions for a period of time. The same is true with high dividend-paying stocks. These payments are often at the discretion of the general partner managing the investment or executives of a public company.
Passive income investments can also require you to lock up your capital for an unknown period. If you have enough liquidity, this could work for you, but if you are not prepared, you often can’t access your initial principal, and the income streams won’t help you.
THE BOTTOM LINE
Creating a passive income stream can be an ideal way to produce income stability for you now or in the future. It’s important to understand if this strategy is right for you as it relates to your current financial circumstance and what you’re hoping to accomplish with your money. We hope that you now have a better understanding of what is and is not considered passive income and give you the opportunity to assess if this strategy could be beneficial to your investment strategy.
Brandy Branstetter, CFP®