The goal of a passive income strategy is to earn money while you sleep. But despite having “passive” in its name, earning this kind of income requires an upfront investment of money and time to generate long-term cash flow.
What is passive income?
Passive income is a cash stream that requires little or no daily effort to maintain, unlike active income, such as cash earned from a full-time job.
Broadly speaking, you can create passive income through investing in certain financial products or by starting businesses that, after an initial investment, start to generate income without regular work on your part.
The IRS treats taxes on active and passive income differently, and has narrow guidelines on what technically qualifies as passive income:
- Trade or business activities in which you don’t materially participate during the year.
- Rental activities, even if you do materially participate during the year, unless you’re a real estate professional.
Experts consider different forms of investment income as passive, but the IRS considers this to be portfolio income, and it is subject to capital gains taxes.
9 examples of passive income
1. Dividend stocks
One way to build an income stream is to invest in dividend stocks, which distribute part of the company’s earnings to investors on a regular basis, such as quarterly. The best ones increase their payout over time, helping grow future income.
Dividend stocks typically are less volatile than growth stocks and help diversify your portfolio. Investors can also choose to reinvest dividends (learn more about dividends and how they work).
» Learn more: 25 high-dividend stocks and how to invest in them
2. Dividend index funds and exchange-traded funds
You can also invest in index funds or exchange-traded funds that hold dividend stocks rather than picking and choosing individual stocks to buy.
Index funds hold a well-rounded selection of many stocks that aim to mirror the performance of a given index, such as the S&P 500. A dividend index fund will invest in a selection of stocks that pay dividends. Index funds can help balance portfolio risk, as market swings tend to be less volatile across an index compared with individual stocks.
Dividend ETFs offer the diversification benefits of index funds while mimicking the ease with which stocks are traded. To invest in dividend stocks, index funds, ETFs or other publicly traded assets, you’ll need to open a brokerage account if you don’t already have one.
» Learn more: Index funds — how to invest and best funds to choose
3. Bonds and bond index funds
Rather than buy an ownership stake in a company through stock, bonds are a way for investors to lend money to companies — as well as federal, state and local governments — and collect interest income. Bonds are considered a safer investment than stocks, but also generally earn a lower return on your investment. For example, from 1926 to 2017, government bonds earned a compound annual return of 5.5%. An index of large stocks earned 10.2% during the same period, according to Morningstar research.
Experts suggest investing a portion of your portfolio in bonds because of their lower volatility and relative safety compared to stocks, then having a higher ratio of bonds in your portfolio the closer you are to retirement.
» Learn more: How to buy bonds
4. High-yield savings accounts
Another way to earn passive income (albeit at a lower level than stocks and bonds) is a high-yield online savings account, which can be ideal for growing your emergency fund. The interest paid by savings accounts is added to your balance.
High-yield accounts are a type of federally insured savings account that earns an interest rate that’s often much higher than the national average. For example, typical high-yield accounts are currently earning around 1.50% annual percentage yield, compared to the national savings average of 0.07% APY. Over time, those small differences add up to real cash, so it pays to shop around for where you put your savings.
» Learn more: 10 best high-yield online savings accounts
5. Rental properties
Purchasing properties to earn rental income is another way to build passive income. Long-term rentals can provide a reliable source of cash if they are located in a healthy market for renters, but they also carry long-term stressors like maintaining those properties, as well as paying multiple mortgages, property tax bills and other costs.
You could also focus on short-term rentals through a platform like Airbnb, which is dependent on a steady flow of visitors to your area. Or, start small: Rent out a room in your house to begin to bankroll your rental property empire.
» Learn more: How to invest in real estate — 5 ways to get started
6. Real estate investment trusts (REITs)
If you want to build passive income from real estate without the fuss and bother (not to mention the hefty down payment) of buying and managing properties yourself, REITs may be the answer.
Similar to mutual funds, REITs are companies that own commercial real estate, such as office buildings, retail spaces, apartments and hotels. REITs tend to pay high dividends, but they vary in complexity and availability. Some are publicly traded on stock exchanges; others are not.
» Learn more: REITs — what they are and how to invest in them
New investors may want to stick to publicly traded REITs, which you can purchase through an online broker like the ones below.
7. Peer-to-peer lending
Real estate investments are long-term bets to build passive income. If you want to potentially earn income and cash out your investment in under five years, one tactic to consider is peer-to-peer lending.
An alternative to traditional bank loans, peer-to-peer lenders, like Prosper and Lending Club, match investors who are willing to lend money with borrowers who are vetted by the platforms for creditworthiness. It’s riskier than putting cash in a high-yield savings account or money market fund, but also potentially can earn more interest — as much as 5% or more.
8. Being a silent partner
Perhaps the original form of peer-to-peer lending, another common form of passive income is funding a private business you believe has the opportunity to generate future income. For high-net-worth individuals, this might be investing in private equity funds, which are typically only available to accredited investors who meet certain net worth or income requirements.
Another way is to back a family member, friend or other trusted partner to help fund their business with an agreement to earn returns from any future profits. But beware: No matter how large or small, investing in a single business is an inherently risky, long-term bet. Never invest more than you can afford to lose.
A way to build passive income at home is to start a blog and build traffic. With a larger reader base, it’s possible to generate revenue through display advertising, using a program such as Google Adsense, or to run sponsored content, which means companies pay you a fee to publish a post on your blog.
Another way to monetize a blog is affiliate marketing, which allows you to earn commissions if your readers purchase a product or service you’ve recommended or linked to. All these tactics require a lot of upfront investment of time to build traffic, as well as pressure to maintain the blog to keep that traffic.
» Learn more: How to make money from blogging