Passive Investor Tips is a weekly series hosted by full-time passive investor and Best Ever Show host, Travis Watts. In each bite-sized episode, Travis breaks down passive investor topics, simplifying the philosophy and mindset while providing tactical, valuable information on how to be a passive investor.
In this episode, Travis explains how passive income is the key to accumulating wealth. He provides examples of different types of passive investments you can make, highlights the top three reasons why someone might consider passive income, and uses a scenario to demonstrate how generating passive income can be truly life-changing.
Types of Passive Investments
Passive investing doesn’t just apply to real estate. There are many different options for earning passive income:
- Owning a business without actively working in that business.
- Owning a rental property that is professionally managed by someone other than you.
- Purchasing a dividend-paying stock where you make the investment once and just sit back and collect the dividends.
- Investing in real estate as a limited partner.
- Publishing a book from which you receive royalties for years to come.
- Making an oil and gas investment and making profits off of oil production.
- Lending money to someone and charging interest.
- Having a whole life insurance policy that is paying an annual dividend to you.
3 Reasons to Consider Passive Income
Long-term capital gains, qualified dividends, real estate — these are tax-advantaged places to put your money.
Passive income allows you to do more of the things you love and less of the things you don’t.
It’s much easier to make more investments and keep adding to your portfolio than it is to keep adding time onto your plate and working more and more.
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Travis Watts: Hey, Best Ever listeners. Welcome back. This is another episode of Passive Investor Tips. I'm your host, Travis Watts. Today we are talking about passive income and how the rich get richer. Disclaimers as always, not financial advice, not telling you or anyone what to do; please seek licensed advice when it comes to your own investing. With that top of mind, the point of the show is to make all of these practical, useful, straight to the point, as little time as possible, and give you the most value that I can. So hopefully, that is appreciated.
So sometimes hearing just a different viewpoint on something can make all the difference. I'm up here just simply sharing my thoughts and opinions, but keep in mind that I'm not the end-all-be-all. I'm not the big guru here in the space that has all the answers. I'm just trying to articulate and clarify what's worked for me, what's worked for thousands of other people, especially when it comes to passive income and the investing space.
In the last episode, we talked about stoicism, and how that can help make you a better investor. And there's another great quote that I want to drop here from Marcus Aurelius, Emperor of Rome 2000 years ago. He said, "Everything we hear is an opinion, not a fact. Everything we see is a perspective, and not the truth." So I'm simply here discussing, again, my opinions; they are not facts. It is my perspective, and it may not be your truth. So with all that, I still hope it adds value anyway, so let's dive in.
So when we talk about passive income, we don't have to think of that in terms of just real estate and cash flow. This could mean any form of investment that you make, where you're not actively involved in the business, and therefore not trading your active time in exchange for money. So I'll drop a few ideas here to help articulate that point of what I mean. You could own a business, but you don't actively work in that business. You could have a vending machine where you hire an employee to restock it and collect the money and go deposit that into the bank for you. You could of course have a rental property that is professionally managed by someone else other than you, a dividend paying stock, where you make the investment once and just sit back and collect the dividends, a real estate private placement where you're a limited partner. That's what I tend to do the most. Maybe you published a book and you receive royalties for years to come. You made an oil and gas investment and you're making profits off the oil production. Maybe you lent out money to someone and you're charging them interest on that money. Maybe you have a whole life insurance policy, and they're paying an annual dividend to you... And things like -- my wife and I we used to rent out our car when it wasn't in use through a third party app where they would take care of everything for us, and just send us the profits. So to me, all of that is encompassing the words "passive income." That's how I see it, and that's how I'm going to present that in this episode.
So the point is, in a general sense, these are hands-off ways to generate income. So with that in mind, I'm sure you're aware that this is not the norm of what we're taught about money and what to do with our money. Instead, we're taught things like "Put money into a retirement account, wait till you're 60 and take a peek at it. Hopefully, that looks like a good number to you. Do the company match with a 401k, put money in the bank and save for a rainy day, buy a property at a low price, fix it up, sell it for a higher profit, pay down your mortgage, buy cryptocurrencies, buy gold and silver, buy a car..." You get the point. None of these things, generally speaking, are cashflow or passive income producing assets or investments. It's just what we're marketed to, and it's what we're told to do with our money.
So in this episode, we're talking about how the rich get richer, and it's interesting, because what you see in the mass media and on TV is actually contrary to what's really going on and how the rich really get richer. So on TV, you might see lottery winners, highly paid celebrities and athletes, or net worth millionaires or billionaires who own big companies, or have lots of shares of stock in a particular company. But one of the tried and true ways that the rich get richer is by investing in passive income. So let's use the game of Monopoly as an example. Hopefully, you're familiar, have played that game. If you're not, I don't have time to explain it to you; go check it out, it's a good game. But we all start out a monopoly with some amount of cash in hand; you make it around the board all the way, and you pass Go, and you get whatever it is, 200 more dollars. That's like your paycheck. But what happens in that game? If you hoard your cash and you never buy properties that generate passive income for you, you end up going bankrupt, right? You end up eventually having to spend more money than what you're bringing in, and that brings bankruptcy. So the point is, it's literally impossible to win the game of Monopoly without buying passive income opportunities.
So I thought this was interesting... Before this episode, I came across something I was unfamiliar with, and it's that the IRS publishes something called the IRS Data Book, and it tells us, if you read through it - and it's on .gov, and all that kind of stuff - that people who make over a million dollars a year, nearly 83% of their income is derived from rents, royalties, dividends, and interest. These are profits that come from passive investments. And by the way, 65% of these millionaires derive from at least three different income sources. So while they may work for active wages also, there's usually a specific reason at why they do that. So that alone, my friends, is the simple answer to how the rich get richer, right? They're investing for passive income. But why invest for passive income? That's what I want to dig into a little more, so I've come up with something I want to share with you. It's a couple of different case studies I want to explore.
Break: [00:07:04.25] to [00:08:59.23]
Travis Watts: First I'll highlight just three reasons, though there's many more, why someone might consider passive income. The first is taxes; long-term capital gains, qualified dividends, real estate - these are tax advantaged places to put your money. Number two is time. So what I always say is passive income allows you to do more of the things you love and less of the things that you don't. We only have so much time and energy in any given day, week, month or year... And the last thing, number three, I'll say, is scalability. It's much easier to make more investments and keep adding to your portfolio than it is to keep adding time onto your plate and working more and more.
So let's explore that in an example purposes only scenario, where we have two different people. One is a self-employed, highly-paid individual, the other has an active job, but is mostly a passive investor. So in the first example we'll use a lawyer, and we'll say that she in this example work 70 hours per week, and that she bills out $300 per hour. If you run the math, that's generally (rough numbers) about a million dollars per year in gross income. So now let's bounce back to taxes, time and scalability.
Number one, taxes. We'll say she lives in Massachusetts. And I use that because they have a nice, even, round number on their state income tax. It's 5% right now. So she would owe 5% of her million dollars in wages in state tax, 37% federal tax bracket - again, these are just loose numbers, if you just look at the brackets; I know it might be more like 36 or 35, or something. But this is just the example I painted. And then because she's self employed, there's a 15.3% self-employment tax on self-employed individuals. So effectively, she's paying 57.3% in taxes. More than half of her total income is gone due to taxes. Now let's look at her time.
So in order to generate the income she has, she's required to work 70 hours per week, four weeks a month, no vacations, no breaks; if she stops working at any point, her income would go to zero at that point. Now let's look at scalability. So it would not be easy to scale this type of income, because she's got really two things she can do. She can add more hours to each week, even though she's already working 70 hours per week - so that sounds like a recipe for burnout to me - or she could raise her wages, but at the risk that she may lose some clients in the process and therefore end up with the same or maybe even less income than she had before.
Alright, now let's transition and look at this employee W-2 active income earner, who still makes a million dollars per year just like the lawyer, except only 200,000 is coming from the job or the active wages, and 800,000 per year is coming from passive income investments. So because they still both work actively for some portion of their income, they're still subject to the same taxes; we'll use that same Massachusetts example, 5% state tax, but this time, the Federal bracket's lower because the income's lower, so we'll go with 32% for this example. And then 7.65 Social Security and Medicare tax. That's because when you're an employee, that cost gets split; that 15.3 becomes half of that, because the employer is paying the other half. So a total of 44.65% in taxes, versus the lawyer paying 57.3% in tax.
Now, depending on how this passive income is generated - there's lots of opportunities, as I pointed out earlier; some may be tax-favored, some may be tax-free, in some cases, some may be taxed at ordinary levels. So just for some simple math, we're gonna go with the middle of the road. I'm gonna throw 15% tax over the passive income that's generated, all 800,000 of it. So if you run it dollar for dollar, the lawyer's paying $573,000 per year in tax, and the investor/employee is paying $209,300 in tax. A very substantial difference. But what's more is to look at the fact that maybe this employees/investor is only working 40 hours per week, instead of 70 hours per week. Maybe he's got health benefits or health insurance, maybe a 401K match, maybe time-off benefits... So there's a lot of other benefits besides just the money and the taxes. At the end of the day, I think we could just agree he has more flexibility over his time.
Lastly, in terms of scalability, the cool thing about the employee/investor is he doesn't need to get a raise or rely on his wages to increase his income. While that might happen, what's more important is he could just keep making more investments for more income streams, or he could let his existing investments keep rolling over, because they produce passive income, and he could be reinvesting in shares of stock if that's what he owns, or buying new investments as he goes along. And this, my friends, paints the picture as to how the rich get richer, and why passive income is so important.
Never tax advice, never financial advice. Please seek license advice. Thank you guys so much for tuning in. This has been another episode of Passive Investor Tips. I'm your host, Travis Watts. Let's connect on social media, Travis Watts are @passiveinvestortips on Instagram, Facebook, Bigger Pockets, LinkedIn; you name it, I'll be there. I appreciate you guys. Like, subscribe, comment, share these episodes with anyone you think could find value. We will see you on the next episode. Have a Best Ever week, everyone!
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