Passive income is broadly defined as money that comes from investments rather than employment wages. Examples include dividend income generated by stock investments or rental income derived from property you own. Passive income can play an important role in helping to meet day-to-day expenses and to accumulate wealth for retirement.According to research from Ameriprise Financial, 40% of investors across multiple generations have some form of passive income, and more than two-thirds (77%) of investors say passive income is important or very important to their retirement strategy.Having more than one source of income to draw from can be a powerful way to hedge against risk and ensure you have the means to cover your expenses. This is particularly true for retirees who no longer earn a traditional income and need to recreate their paycheck.
Five primary ways to generate passive incomePassive income can originate from a variety of sources. Here are five ways to generate passive income that may be a fit for your financial portfolio:#1 Dividend-paying stocks and mutual funds or ETFsStocks that generate competitive dividend yields are a prime source of passive income. If choosing individual stocks, pay attention to their track record. Companies with a history of raising dividend payouts consistently over time may offer the best, long-term opportunity. You can also find mutual funds or ETFs that emphasize dividend-paying stocks.#2 Bonds and bond index funds or ETFsInvesting in bonds is another way to generate income. Even if you are in the accumulation stage of life, bond income can play an important role in helping you build wealth. Not only do bonds offer a way to diversify a stock portfolio, but in today’s market, bond yields are increasingly attractive. Consider that at the end of 2021, the yield on the benchmark 10-year Treasury note was 1.52 percent. At the end of Aug. 2023, the yield was more than four percent. Bond funds and ETFs are generally offering more competitive payouts today as well.
Like bonds, cash-equivalent vehicles such as money market funds and certain certificates of deposit and bank savings accounts pay more attractive yields today. This is in line with changes to the yield environment in the broader bond market. Money put to work in this way generally has the added benefit of protection of principal value. Not only can you earn competitive returns, but you do so in a relatively safe manner.Some people choose to own property, such as houses or apartments, rent them out and use the income to buffer their nest egg. While this is considered a passive investment, there may still be some sweat equity and ongoing costs involved in maintaining properties and attracting and managing tenants. You’ll also want to pay close attention to the state of the real estate market where you invest in properties. Ideally, these properties will appreciate in value over time.#5 Real estate investment trustsIf the idea of generating income from owning properties appeals to you, but you don’t feel prepared to tackle the challenge of direct ownership, REITs offer an alternative. REITs are professionally managed like mutual funds, with money invested in properties such as office buildings, apartment complexes, retail spaces, warehouses, or hotels. Those who invest in REITs primarily benefit from the income stream generated by the properties held. REITs are subject to market risk and various fees, and dividends are taxed as regular income. Evaluate any investment options carefully to understand how they may impact your situation.Work within your overall planPassive income is most effective when the investment strategy is implemented within the context of your overall financial plan (with the plan itself designed according to your unique goals, timeframe to achieve them, and level of financial risk you want to accept along the way). Work with your financial advisor to determine how best to incorporate passive income strategies. A professional can discuss the advantages and drawbacks of the strategies above in more detail and point you to other options not listed here. As a final tip, keep in mind that while passive is in the name, you should regularly review your passive income strategy to make sure it’s helping you achieve your financial goals.—Gregory Parsons, CFP®, CRPCTM, APMATM is a Financial Advisor in Kaufman, TX.