Dec. 4, 2018
When it comes to building wealth, saving and investing for your future and achieving whatever other financial goals you might have, it's important to develop other sources of income other than what you earn. You could be earning $500,0000 by age 50, yet if you haven't saved a dime, you're not going to be able to retire anytime soon.
This article will explore the different types of income, how to establish other sources outside what you earn, and why it's important to begin thinking about and establishing these sources early.
Earned income is money you actually earn from your job and requires your time commitment. If you're paid a salary, commission or wage, they would all fall under earned income. This is the most common type income people receive.
Throughout our careers, the hope is our earned income will grow. We gain more experience, become more efficient, and provide more value to customers or employers, which in turn, leads to a higher compensation for our time.
While earned income is certainly important, it will never by itself lead to financial independence or the ability to "retire" from the full-time job paying you the earned income. You must establish other forms of income in order to reach financial independence or retire.
Portfolio income is money you earn from selling an investment that produces a capital gain. This can include stocks, bonds, exchange-traded funds (ETFs), mutual funds, real estate, or even cars.
Establishing portfolio income within an employer's retirement plan is often where many investors get started. In the case of 401(k)s, you're able to set aside a chunk of your pay into a tax-advantaged account to invest for retirement. These funds, using the power of compound interest and time, will ultimately be relied upon as a source of income in retirement when you may no longer have earned income.
Some investors will establish other forms of portfolio income outside their retirement accounts. Brokerage accounts have no contribution limits but they're not tax advantaged. It's important to ensure you're being tax efficient with your investments inside a brokerage account. Once investors have maxed out retirement contributions or want to invest funds that aren't subject to a 10% penalty on early withdrawals, they have the option to invest via a brokerage account.
Portfolio income is also taxed more advantageously than earned income. Money that you earn, you pay income tax on. Depending on your marginal income tax bracket, that could range anywhere from mid 20% to high 30s. Investments are taxed at either long-term capital gains or short-term capital gains (same as your marginal tax bracket). When you hold an investment for longer than one year, you pay less in taxes at long-term capital gain rates, typically 15% or 20% on the gain. You can also use capital losses to offset gains.
It's important to have portfolio income as an option when it comes time to retire because it's the easiest way to build real wealth. Our market system allows anyone who wants to own a public company and benefit from their earnings and growth, to be able to do so. It's amazing what 20-30 years of compounded growth can build to help you become financially independent and no longer rely on earned income.
Passive income is associated with anything you're not actively engaged in to produce a cash flow. You often hear these sorts of income streams referred to as "side hustles" or online businesses people establish to supplement their earned income. While the IRS doesn't view passive income in the same way, for the sake of the point I'm trying to make with this article, we'll refer to it as it's now often referred to online.
Developing alternative forms of income to supplement what you earn from your day job is a great way either enhance your current lifestyle or to invest more for future you. Whether that be investing directly in real estate, an online business, or shelling out cash as a "passive" partner in a business, you're allowing capital to work for you and produce an income stream.
Be wary that passive investments often carry greater risk than investing in a stock market index fund. An S&P 500 index fund, for example, spreads its risk across 500 of the largest companies in the U.S, where a passive investment in real estate involves owning one piece of land or property. Concentration results in greater risk from an investing perspective. The same goes for when you invest directly in a business.
The benefits of establishing a passive form of income are clear. It can produce a steady cash flow and potentially be worth significantly more down the road.
Building Earned Income
Now that we've covered the various types of income, let's explore how to start building them. As I mentioned earlier, most can expect their earned income to grow as they progress in their careers. Asking for compensation increases, in the form of salary, stock options or other benefits, can be a useful and rewarding skill. Given that you're actually providing value above what you're currently compensated at, or in line with peers with similar roles, you shouldn't feel wrong in asking.
Building Portfolio Income
Building portfolio income over time, in my opinion, is the easiest way someone can become financially independent. All that's needed are three ingredients. Time, recurring and increasing contributions and compounded growth. Millennials have a surplus of time to invest with ages ranging roughly between 20-36, depending on who you ask.
Paying yourself first and setting aside more money as you earn more, is key to being able to become financially independent earlier and without having to change your lifestyle.
Lastly, the U.S stock market historically has grown between 8-10% depending upon the period of time you measure from. This means you can earn on average between 8-10% in an equity portfolio and all you have to do diversify properly, rebalance and be smart about taxes. Although investment management isn't for everyone, that's partly why we have a job. Some people don't want to do it themselves, don't trust their emotions when markets recede or just want a professional to do it for their peace of mind.
Building Passive Income
Building a passive stream of income isn't a necessity if you've built a sizable investment portfolio by the time you retire. However, it is an effective way to increase your cash flow, which in turn can be used to finance travel or experiences on the bucket list. Or it could be reinvested or put towards an investment portfolio.
Passive income is a rather broad definition in the context of personal finance and how the online world has come to use it. To get started, it requires some sort of upfront capital. Whether you're investing in real estate or an online business, both will take a particular amount of cash to get started. In order to build up the necessary amount of cash, you should have a good idea of roughly what the endeavor will cost.
Next, you'd want to start setting aside portions of your earned income every pay period towards an account designated for whatever you're pursuing. For short time periods, it probably doesn't make sense to invest the cash.
It's important to do the research, talk to professionals and be as prepared as you possibly can with any investment you make. Don't fool yourself that buying a piece of property or an online business will immediately and directly result in a positive cash flow without putting in the research, preparation and time necessary for it to be successful.
The Bottom Line
People who don't establish some form of assets and income outside their earned income will either retire later than they'd prefer or have to make drastic changes to their lifestyle in order to ever retire or become financially independent.
Working on building different sources of income and assets outside of what you earn at your full-time job will set your future self up for success and provide you the flexibility to begin crossing those Caribbean islands off the travel list.