Passive income (or residual income) is money that you expect to earn on a regular or semi-regular basis that you don't have to do any significant additional work to receive. Some examples include royalties, investment income, rental income, interest income, and residual sales commissions.
Active income, on the other hand, involves trading time for money. You have to keep working to receive it. If you stop working, you stop receiving. This includes hourly and salaried income, one-time commission income, independent contractor payments, and most work bonuses.
An easy way to tell the difference between active and passive income is to ask yourself how much money you'd expect to receive this year if you stopped working. Your active income stops when you stop working. Your passive income continues to flow whether you're working or not.
This is an oversimplification to some degree. Most passive income isn't 100% hands-off. You may have to invest a small amount of time and effort to keep the flow going, such as maintaining your investment accounts, but perfect passivity isn't necessary to enjoy the benefits.
Society conditions most of us to work for active income. We're taught to go out and get jobs to earn a living. But this can become a trap because active income turns off when you stop working. If most or all of your income is active income, it's hard to get ahead financially. It's also difficult to have much of a life outside of work if you have to keep working year after year to bring in enough money to pay the bills — or risk going broke.
Of course you can push yourself to earn a higher hourly rate, and that can ease some of the burden if you manage to live well below your means. But quite often when people earn a higher salary, their expenses creep up as well. Many people refer to this as the rat race. It seems like you're working harder and earning more, but you're still just as trapped as you were when you started. You can't afford to stop. Even pausing for a while means you'll hurt yourself financially.
You can also try to build some savings. However, if you're using active income to build your savings, then your savings stop growing when you stop working. And if you go too long without working, then you may have to dip into your savings to cover your expenses. I think it's even better to build savings with passive income, so the amount continues to grow whether you're actively working or not.
Making the Choice
I was lucky to learn this distinction between active and passive income during my 20s, mainly by reading books written by successful entrepreneurs. At some point I made the decision to focus on building streams of passive income instead of relying on active income.
This required some short-term sacrifice. I had to think long-term. I realized that any dollar I earned by trading time for money is like planting a seed, letting it grow a little, and then ripping the plant out of the ground and consuming it. Every year I have to start over and replant.
On the other hand, passive income is like planting a fruit tree. It takes a while for the tree to mature and to start bearing fruit, but then I can keep going back to it year after year to enjoy more fruit from the same tree. Whatever I consume will simply grow back.
I was running my computer games business at the time I made this decision. For the first 5 years of the business, I did contract work for other publishers. But I could never get ahead that way. So instead I decided to focus on building my own direct sales over the Internet. I released small games with downloadable demos that people could play for free. Eventually I was earning thousands of dollars per month from game sales. The income was mostly passive because the sales were fairly stable, and it didn't take much work to maintain the system. Most of my work time was focused on releasing new games to increase sales. The more games I released, the more income streams I enjoyed.
Some of the games I released didn't sell very well. However, they still brought in a little extra money, month after month. For some games the sales were only around $70 per month, but the money kept coming in month after month like clockwork — for years. That's $840 per year in passive income. Even if you have a lot of little streams that don't do so well, it adds up. When it comes to passive income, even a relative flop still puts some extra money in your pocket.
And if you just keep trying, eventually you may get a hit. Some projects have generated hundreds of thousands of dollars in residual income for me. Even years after the original project has been completed, I still earn monthly residual payments.
By favoring passive income to support myself, my livelihood isn't attached to the number of hours I work. I can take time off, and my income doesn't suddenly turn off if I stop working. My income can't be fired or laid off, so I never need to worry about unemployment. I expect to keep getting paid no matter what.
Since most of my income streams are related to sales in some way or another, the amounts fluctuate from month to month. With enough streams added together though, this smooths out the bumps. So when one stream goes down, another may surge. And of course I'm not helpless. I always have the ability to create new income streams, and I can always fall back to earning active income whenever I desire.
Passive income reduces financial pressure. I can mostly take for granted that my bills will be covered by my passive income streams. So instead of working for more money, I think about my work in terms of what I desire to create, express, and contribute. I don't need all my work to be driven by financial concerns. If I want to earn more money, I can choose to do income-generating projects and create new streams of passive income. But when the money is flowing well, I tend to be less concerned with it. During those times I'm more likely to focus on doing work simply because I enjoy it, and I don't worry about whether it generates much income. For example, I love to write and share new articles. Writing articles doesn't generate income for me directly, but I can afford to do it simply because I like it, and I know that others appreciate my work.
This is a nice way to work. It's low stress and very sustainable. It's very freeing too because I can do projects that I enjoy, even if they aren't money-makers.
I want to emphasize that this is simply a choice. If you want to generate streams of passive income, you're free to do so. If you want to go the active income route, you can do that too. Society tends to condition us to earn active income, but you certainly don't have to play "follow the follower" if you recognize that passive income will be a better fit for your desired lifestyle. There's no right or wrong choice — it's simply a matter of deciding which set of consequences you wish to experience.
Figuring It Out
For many years, I've been earning six figures per year in passive income. This has included streams like affiliate income, joint-venture deals, royalties, advertising, and donations. I don't need to do much, if any, work to maintain these streams. Money just keeps flowing each month.
I didn't reach this point overnight, however. It took many years of experimentation to figure it out. It was a lot of hard work. Creating passive income may be a smart approach, but it isn't a lazy approach.
Don't expect it to be easy. It can take a lot of experimenting. You have to figure out how to balance 4 different factors: (1) what makes money, (2) what you enjoy doing, (3) what you're good at, and (4) what makes a meaningful contribution.
Ultimately it's important to pay attention to all 4 of these factors. Your best shot at earning passive income will be to incorporate all 4 of these elements into your plan.
Let's consider each of these factors in turn.
It's wise to study the various ways you can make money passively. There are lots of possibilities, but some will work better for you than others. I've found that due to my technical skills and Internet knowledge, it's fairly easy for me to generate passive income online with a website. Other people, however, find it easier to make money by investing in stocks. And still others find it easier to earn rental income from real estate.
What I like about making passive income online is that I can start making money right away with a good idea. I don't need to put any money at risk (mine or someone else's), like I might have to do in stocks or real estate.
Before I figured this out, I read books about various ways to earn passive income, including books on investing in stocks and real estate. Somehow I couldn't see myself as a stock trader. Nor could I see myself as a landlord with a bunch of tenants. I wasted money exploring those paths, only to conclude they were dead ends for me. So I chose a vehicle that I thought would work well for me — generating income online.
I suggest you go to the business section of your bookstore, and browse through the books on different ways to make residual income. There are countless strategies available. You don't have to invent your own. You can simply apply or adapt a strategy that someone else has already figured out. There's no need to reinvent the wheel.
Don't necessarily jump on the first passive income strategy you learn about. Take some time to think about how you'd like to make money. Can you see yourself as an online entrepreneur? An author receiving book royalties? A property owner who receives rental income?
When you think about different possibilities, ask yourself, "Is this me? Can I see myself making good money this way?"
You may find multiple strategies that suit you. In addition to earning money online, I also earn royalties from sales of my book, Personal Development for Smart People, which was published by Hay House. The book has already sold enough copies to earn back the initial advance, so now I get royalty checks twice a year. Since I love to write, this type of income stream is a good fit for me, especially since it's easy to manage.
Enjoying the Work
It's important to enjoy the work you'll be doing to create your streams of passive income. If you don't enjoy the work, you'll probably procrastinate and sabotage yourself.
When I thought about trying to make money from real estate investing, I just couldn't see myself enjoying it. I had no interest in going around looking at properties. The thought of dealing with tenants or a management company made me nauseous. Real estate contracts give me headaches. The work I'd have to do in order to succeed as a real estate investor would have made me pull my hair out. I'd much rather be broke.
Don't force yourself to do work that you don't enjoy. There are so many options for earning passive income that with enough trial and error, you should be able to find something you enjoy doing.
In my 20s I enjoyed writing computer games, so it made sense to use that as a vehicle for passive income. These days I love writing, so that's another good choice for me. If you like doing creative work, then you can generate income by selling or licensing your creative work.
I know some people who absolutely love investing in stocks. I find that sort of thing incredibly boring, but it works for them.
Don't resist experimentation to figure out what you enjoy. It will take as long as it takes. Keep experimenting till you figure it out.
Leveraging Your Skills
Our third criteria is that you need to leverage your skills. It's okay if you're not highly skilled when you're first starting out, but if you wish to generate some serious passive income, then commit yourself to developing some of your skills to a very high degree of competency.
Don't expect to be rewarded for low quality or generic work. If you suck at what you do, you can expect that your income will suck too, whether it's mostly active or passive. Commit yourself to excellence.
Earning passive income doesn't mean you get to rest on your lazy ass and do nothing. It simply means that instead of trading hours for dollars, you'll be using your time to build persistent streams of residual income. It's a good strategy, but it still takes disciplined effort.
Unfortunately there are some unscrupulous marketers who seek to promote passive income as the lazy way to riches. I know a lot of people who earn passive income streams, but I can't think of any who are lazy. They're all hard workers, but they also know how to work smart.
There's no free ride. If you're looking for the easy way out, you'll probably stay broke. You'll also get suckered into buying a lot of info products you don't need, and you'll spend a lot of your working life making other people richer.
When it comes to leveraging your skills, what are you good at? What skills could you develop into major strengths, and how can you use those skills to generate passive income?
For example, if you're pretty good at recognizing the strengths and weaknesses of different houses in terms of their long-term investment value, you could develop yourself into a kick-ass real estate investor. If you're very knowledgable about tech companies, you could develop that skill to become a successful tech investor.
I have a knack for writing, so I pushed myself to become a better, faster writer. This makes it easier for me to leverage this strength to generate streams of passive income. If I was a crappy writer, my income would surely suffer for it.
When you choose a certain strategy for generating passive income, it's important to commit yourself to getting better at implementing that strategy. Become a student of your own passive income streams. Learn from others in the same field. Don't be complacent. Keep reading books, attending conferences, and going to seminars. Be a lifetime learner.
Making a Contribution
The final key to creating passive income is to make a meaningful contribution. If your work doesn't contribute, then essentially you're trying to mooch value from other people, and that isn't sustainable in the long run. Just ask Bernie Madoff.
This is especially important if you're trying to shift your work from active to passive income streams. Ask yourself, How can I positively contribute to the lives of more people than I'm reaching now?
For example, if I worked as a personal coach, that would be an active income strategy. I'd only get paid while I was actively coaching people. My income would be limited by the number of clients I could manage.
If I switch from one-on-one coaching to professional speaking, then I can reach more people at the same time. I could potentially earn a lot more money this way. However, when I'm not actively speaking on a professional basis, I'm not earning income.
But what if I record video of my speeches and put them on a website? Now I can reach people 24/7, and I don't even have to be there. This may not be as intimate as coaching people one-on-one, but it can potentially touch the lives of many more people. With these recordings I now have the potential to generate passive income too. I could post them for free to build web traffic and then monetize the traffic in other ways (advertising, affiliate programs, donations, etc). Or I could sell the videos directly. Or I could license the videos to another company to turn into products, and they could pay me ongoing royalties from sales. There are lots of options.
If you want to generate passive income, ask yourself, How can I provide value to people when I'm not physically there? Passive income comes from passive value. If you figure out how to provide value to people when you aren't there, then it's usually not that difficult to figure out how to turn it into an income stream. All you have to do is ask people to pay for some of that value, either directly or indirectly.
It will take some experimentation to discover the best ways to contribute. You may create something that other people simply don't value, like a product that no one buys. Don't worry about the failures. Just keep testing new ideas. Eventually you'll figure out what works.
Obviously I keep emphasizing the importance of experimentation. Experimentation is critical. You're going to make a lot of mistakes, but that's okay. Every mistake helps you make new distinctions. You won't suddenly wake up in passive income nirvana someday and discover that everything is perfect. You'll always be learning new ideas and tweaking your streams. I've been earning passive income for more than 15 years (and the vast majority of my lifetime earnings have been from passive income sources), but I still feel like there's so much more to learn and to test. I think it's wise to accept that you'll never get it perfect, but you can still enjoy tremendous benefits by getting it mostly right.
Sticking to the Plan
If you want to enjoy the benefits of passive income, then you'll have to make it a priority in your life. It's not going to happen automatically. It will take some effort and hard work. But if you strive to balance the four aspects I mentioned above, then you'll probably find the work motivating and rewarding. You should also feel good about how this work continues to develop your strengths and talents. Yes, it's work, but it's work that feels good.
Let me warn you in advance that society will try to keep nudging you in the direction of active income. If that isn't what you want, then you'll have to muster the strength to stick to your guns. Forget about getting a job. Focus on building a cool life instead.
After I graduated from university, my friends went out and got corporate jobs, while I chose an entrepreneurial path. In the beginning, I struggled to pay my rent while they bought condos and new cars. In the long run, I think my strategy was the better choice. Now I get to enjoy a lot of freedom, while people who chose the active income path are still stuck on the job treadmill. Many of them are now bored and frustrated with their corporate jobs. They wish they had more freedom.
I especially notice the difference when it comes to skills development. My corporate job-wielding friends got really good at pleasing their bosses. They developed specialized skills that they apply over and over to similar types of projects. Their skills development has been very narrow and limited; outside their field, their skills don't matter much. During this same time, I learned how to build successful online businesses, to write well, to speak professionally, to do workshops, to do interviews, to negotiate business deals, etc. These high-level skills give me a lot of leverage, making it harder for me to fail.
This isn't all or nothing. You can still earn active income whenever you desire. I did several 3-day workshops last year, and I recently started offering phone consultations because I happen to like coaching people one-on-one. I earn enough passive income to cover my business and personal expenses, but I still have the option to generate active income if I so desire. Passive income simply gives me more freedom of choice.
It's really nice having a solid base of passive income. It can take a lot of work to reach that point, but it's worth the effort. Most people won't invest the time and energy to go this route, but most of them can't afford to stop working without seeing their income drop dramatically. I think it's nicer to know that you can take a few months off now and then, knowing that your income will keep coming in whether you're working or not. Work because you want to work, not because you have to work.