I often dream about the day when Nicole and I will be able to spend our weekdays relaxing on a beach underneath the afternoon sun. The thought of not having to worry about the stresses and commitments of working sounds divine. More importantly, being in charge of our own time has always been incredibly alluring. We recognize that accomplishing a goal of this magnitude will take time, planning, and dedication. We certainly aren’t there yet, but we are diligently working to build streams of passive income to turn our dream into a reality.
In my last blog post, I mentioned that Nicole and I have a bias toward dividends when it comes to passive income. In addition to dividends, there are several other options for earning passive income. I’ll elaborate on a few alternative sources of passive income and explain why Nicole and I are such big fans of dividends.
Although I don’t have the statistics to back it up, I would imagine that the most common type of passive income comes in the form of interest earned on savings account balances. There was a time when savings accounts boasted interest rates well over 5%. However, in the current environment, you would be hard-pressed to find an interest rate remotely close to that. Currently, most high-yield savings accounts have interest rates around 1%. According to Bankrate, the average interest rate for savings accounts in the U.S. is a measly 0.1%.
Nicole and I have a high-yield savings account with Ally Bank. At 1.00%, the interest rate is quite competitive. While we don’t anticipate receiving much interest income each year, it’s reassuring to know our money is being more productive than if it were stuffed under our mattress.
Certificates of Deposit (CD)
A certificate of deposit, often referred to as a CD, has some similarities to a savings account. Like savings accounts, CDs are offered by most banks and they too pay interest on the account balance. Unlike a savings account, a certificate of deposit will typically require you to “lock up” your money for a designated period of time. The term of a CD can be as short as 6 months or longer than 5 years. Generally, the longer the term of the CD, the higher the interest rate.
Since you are agreeing to have your money “locked up” for a designated period of time, the interest rates of CDs are generally higher than the interest rates of savings accounts. One downside of CDs is if you need to access the money in a CD before it matures, you will typically forfeit a portion of the interest earned or be required to pay a small penalty.
Nicole and I don’t currently utilize CDs. There were times in both of our lives when we each had a CD. I believe I was in junior high school when my dad and I went to the bank to open a CD. I can still remember being excited to see the amount of interest earned each month when I received my statement. Even though the CD was probably earning less than $0.50 per month, I thought the idea of money creating other money was so cool!
Due to the low interest rate environment we find ourselves in, relying on savings accounts and/or CDs to provide a substantial amount of passive income most likely isn’t the best option. Taking inflation into account, chances are the money held in these types of accounts will actually lose purchasing power over time. With that being said, savings accounts and CDs both offer some attractive aspects that enable them to be great resources in certain situations.
One way companies can reward their shareholders is in the form of dividends. A company has the option to distribute a portion of its earnings to its shareholders in the form of a cash payment. That cash payment is called a dividend. If you’re unfamiliar with dividends, you can read this blog post for a more in-depth look.
The dividend yield on companies’ stocks can vary significantly. For example, the dividend yield for Microsoft (symbol MSFT) is about 0.94% ($0.51 quarterly dividend x 4 / $216.50 share price as of market close on 08/03/2020) and the dividend yield on Verizon Communications Inc. (symbol VZ) is about 4.30% ($0.615 quarterly dividend x 4 / $57.24 share price as of market close on 08/03/2020).
Earning dividend income requires a bit more involvement than the passive income provided by a savings account or a CD. Instead of simply parking your money in a bank account, you would need to decide which company/companies to invest in and purchase shares of that company’s stock.
Dividends are our preferred choice of passive income for a few reasons. Our qualified dividend income is taxed at a 0% rate, earning dividend income requires limited work after the initial purchase, and reinvesting dividend income is an easy way to realize the benefits of compound growth.
Preferential Tax Treatment
In 2019, Nicole and I earned $2,468 in dividend income in our taxable accounts. Of that amount, $2,323 was qualified dividend income. A dividend payment is deemed to be qualified if it meets certain requirements identified by the IRS. Form 1099-DIV provided by your broker at the end of the year will even note the amount of qualified dividends you received throughout the year, so you don’t have to keep track of them on your own.
Under the current legislation, qualified dividends are taxed at preferential rates (the long-term capital gains rates) compared to other forms of income. Depending on filing status and amount of taxable income, the tax rates on qualified dividends are currently 0%, 15%, or 20%. The chart below from Bankrate shows the tax rate that applies to different income levels for tax years 2019 and 2020 for each filing status.
Since Nicole and I had taxable income of less than $78,750 in 2019, all of our qualified dividend income was taxed at a rate of 0%. Our goal for 2020 is to earn over $5,000 in dividend income in our taxable investment accounts. It’s a substantial increase when compared to last year’s figure, but we have been diligently working to reach that goal. Since we expect our taxable income for 2020 to be less than $80,000, all the qualified dividends we earn during 2020 should be taxed at a rate of 0% as well. The preferential tax treatment makes qualified dividends quite attractive as a source of passive income!
Limited Work Following Purchase
After identifying and purchasing shares of the dividend-paying company, the majority of the work is complete. As a shareholder, there is no responsibility to run the day-to-day operations of company. You don’t have to supervise employees or get involved in office politics. Once you own the shares, you simply wait for the quarterly dividend to be deposited into your account.
Let me be clear, when investing in dividend-paying stocks, one shouldn’t necessarily have a “set it and forget it” mindset. Investments should be monitored on a regular basis (I monitor each investment in our portfolio at least quarterly). If there is a material issue with the company’s ability to generate revenue or new regulations that negatively impact the company, reevaluating the investment altogether might be a good idea. “When the facts change, I change my mind” is a popular quote from John Maynard Keynes that I keep in mind when reviewing our investments.
Automatic Dividend Reinvestment
To reduce our involvement even further, Nicole and I are big proponents of automatically reinvesting dividends. While dividends typically increase the cash balance of your account, most brokers provide the option to reinvest dividend payments directly back into the company that paid the dividend. For us, it was as simple as updating an option in our account settings. By automatically reinvesting dividends, we remove the responsibilities of constantly keeping an eye on our cash balance and save time by not having to manually place trades to reinvest dividend payments. Best of all, most brokers will automatically reinvest dividends free of charge!
The chart below illustrates the impact of reinvesting dividends and illustrates how powerful the compounding effect can be. The reinvested dividends are used to purchase additional shares of stock which will pay dividends in the future. Those dividends will be reinvested to purchase additional shares of stock which will pay dividends in the future . . . and the process continues in perpetuity. In the example below, reinvesting dividends over a 10-year period would result in an additional 30% of annual income in the tenth year compared to the first year.
The last type of passive income I’ll discuss is rental income. I’m not sure if it’s just in my head, but it surely seems like earning rental income has grown in popularity in recent years. The way I view it, rental income is any type of income you receive from renting out an asset you own. Whether it’s renting out a house, an apartment/condo, farm-land, or a vehicle, it’s considered rental income in my book. Compared to the other methods already mentioned, most rental income requires more time and effort, especially up-front.
Due to the number of considerations (location, property type, target market, etc.) the expected rates of return on rental income can vary drastically. I won’t even attempt to provide a range because each situation is truly unique.
Over the past few years, Nicole and I have dabbled in rental real estate a bit (I’ve made a couple of posts about our experiences so far, so be sure to check out Part One and Part Two of our Rental Real Estate Endeavors). Nicole purchased a house in Auburn Hills shortly before she graduated from college. We initially lived in the house for about a year and rented out a few of the rooms at the same time. When we purchased our house in Bloomfield Hills, we continued to rent out the Auburn Hills house for a couple of years. After recently selling the Bloomfield Hills house, Nicole and I are once again living in the Auburn Hills house. We still rent out a couple of rooms in the house (often referred to as “house hacking”) to drastically reduce our expenses.
While Nicole and I aren’t sure if rental real estate is for us, we wanted to give it a try before counting it out. There’s a lot of information that I want to share about our rental real estate endeavor, but I’m planning to dedicate an entire post (or two) to the topic.
Even if you enjoy your job, there are probably plenty of people, experiences, and adventures to which you would prefer to dedicate your time. Creating streams of passive income can help provide you with additional flexibility and freedom, but it most likely won’t happen overnight. It’s important to develop a systematic approach that allows you to increase the amount of passive income over time.
While every type of passive income might not be right for your situation, I’d be willing to bet that there is at least one type of passive income that pairs well with your situation. It might take some time, a bit of trial-and-error, and a lot of research, but I’m confident that you can find the type of passive income that’s right for you.
As always, I’d love to be able to answer any questions you might be pondering or thoughts you might have.
Your thoughts are worth more than a penny.