Have you ever heard the statistic that millionaires have an average of seven streams of income?
I tried to find the survey, report, or some official repeating that statistic but was unsuccessful. That said, seven sounds good to me.
More importantly, how do we get them? (if you want to jump ahead, here are some great passive income ideas)
What spurred this blog post was an idea put forth by my friend at ESI Money in which he talks about how the first million is the hardest. ESI shares how his net worth growth has accelerated. The first million took 19 years of work (the clock starts when he started working, not at birth!) but the 2nd million took just 4 years and 9 months.
The more money you have, the more money you’ll get. 1% of $100 is just a dollar. 1% of $100,000 is a cool grand.
The rich do get richer – here’s the playbook.
Table of Contents
- Active income vs. Passive income
- How do you accumulate wealth?
- You are subject to financial gravity
- Grow Your Active Income First
- Then Grow Your Passive Income
- Common (passive) streams of income
- Interest (#1) and Dividends (#2)
- Capital Gains (#3)
- Royalties (#4)
- Rental income (#5)
- Business income (#6)
- How I built my streams of income
- My 7 streams of income (updated 2021)
- Not all passive streams are equal
- What’s the point…
Active income vs. Passive income
Let’s start by talking about making money, or, your income.
There are two types of income – active and passive.
Active income is when you do work and are paid for that work. If you work at McDonald’s, you are paid for the hours you work. If you work in an office, you may not clock in and clock out but you are paid based on the work that you do. If you do nothing, you will no longer be paid.
Passive income is when the payment is not directly tied to active work. Interest and dividends are prime examples of passive income. Typical passive income sources are front-loaded with active work, for which you are paid a small amount, while the bulk of the income comes later.
Don’t mistake passive income with zero work. It’s a classic misunderstanding about passive income.
It’s still working, it’s just that your income is not directly tied to the hours worked. Anyone who owns rental properties knows that it’s considered passive income but there is quite a bit of work involved. The work is front heavy but if you are lucky, you can collect rental checks without incident for many months before having to do work.
How do you accumulate wealth?
Here’s the next key to the puzzle.
The key to accumulating wealth is uncomplicated:
- Sell your time for money,
- Spend less than you earn,
- Invest your savings so it will grow without your active intervention.
That’s it. It’s a simple input and output problem.
There is just one constraint on the whole system — your time in this world.
You have just 2.21 billion heartbeats. At 60 beats per minute, that’s a little over 70 years. Each beat matters.
There’s another constraint, and here is where wealth inequality rears some of its ugly head, and it’s known as Maslow’s Hierarchy of Needs.
You need to eat. You need a place to sleep. And both of those, and other needs, require money.
So in an ideal world, you could take your time to build a massively successful business (or maybe a few failures before the massive success), but in the real world, you need a job that will pay you now so you can feed yourself, clothe yourself, and secure a place to sleep.
I call it financial gravity.
If you want to really start tracking your finances, and I mean not just your spending but your investing (that’s where wealth is built), give Personal Capital a look. It’s a cornerstone of my financial system and I think you owe yourself a look. 100% free too.
You are subject to financial gravity
Think of your net worth as an airplane. You are trying to get it into the sky and soar effortlessly.
On Earth, we are all subject to the same gravitational force. The larger you are, the more that force exerts on your body. If you weighed nothing, you would fly away.
Financially, our net worth airplanes are all subject to the same financial pull. Where you choose to live, how you choose to live, the products you buy, etc — they will determine how large and heavy your plane will be to hold all that stuff. The greater the need (monthly expenses), the more thrust (income) you’ll need to take off.
Your net worth airplane takes off when your thrust (income) exceeds your gravity (expenses).
Additionally, there will be a transition point when it’s less like a plane and more like a rocket. It’s when passive thrust plays a greater role than active thrust. Your investments, hopefully, grow to the point where they exert the greatest impact on your net worth and your income and savings (income minus expenses) plays a smaller role.
That transition point can be challenging to navigate but it is also very freeing.
Grow Your Active Income First
If you have no other resources, you start by focusing on active sources of income (job) until you’ve saved enough so that you can build up passive resources.
When it comes to the idea of saving money, there are two schools of thought:
- Save more – This school has you focus on living “frugal” and cutting your expenses to the bare minimum.
- Earn more – This school has you focus on earning more, on side hustles, businesses, etc.
It’s a false dichotomy. You can do both and you should do both.
The difference is that cutting expenses is immediate, much like active income is immediate, whereas earning more is often a long term play, like building sources of passive income. So you cut what you can now (e.g. cut your cable) and secure immediate savings while you build up your passive sources (e.g. put cable savings into dividend stocks).
The importance of saving money, especially early in your life, cannot be overstated.
When you start with nothing, or close to it, you are forced into active income. What you can save can be converted into passive income. If you don’t save that active income, through your own choices or choices thrust upon you, you will be stuck in that phase forever.
Many of those passive income sources, like qualified dividends and long term capital gains, also get extremely favorable tax treatment. If you’re in a low tax bracket, you may pay zero taxes on capital gains. If you are in a high tax bracket, it’s only 15% – far lower than ordinary income tax rates.
Then Grow Your Passive Income
I think of each passive stream as falling into one of two categories:
- You build something (business) that provides value and then capture some of that value.
- You lend money to someone who will build something of value and they pay you for that money.
In both cases, you need savings.
When you build a business, you’re giving up active income (instead of working for pay, I’m volunteering at my own business) for future active and passive income. In the meanwhile, you’ll need a way to pay for your expenses. It could be that you’re building a business on the side, so you still have a day job, or you’re living on those savings. Either way, you need a cushion.
When you lend money, you’re lending your savings to someone who will put in sweat equity to grow it into more.
All of those potential future passive streams rely on having savings.
Common (passive) streams of income
As you build up your savings and envisage your future passive streams of income, here are some of the common ones (here’s a longer list of 21 passive income ideas). The numbers are arbitrary and meant just to keep track of the number of common streams.
Interest (#1) and Dividends (#2)
The two most common passive income streams are interest and dividends.
Interest can come from a variety of sources but the two biggest are from your interest-bearing deposit accounts (like a savings account) or loans, either to individuals (peer-to-peer lending or private notes) or companies (bonds, notes).
Interest is not super sexy to think about but it’s also something that requires very little effort. We make sure we put any savings into a high yield savings account and then never think about it again. It’s like getting cashback on a credit card – you pick the card once and just get a small drip in return.
Dividends are payments from investments and partnerships. When you start, most of your investments will be in the stock market and you benefit from qualified dividends and their favorable tax treatment. As you expand your portfolio, you may enter into partnerships that make payments.
The holy grail of dividends is qualified dividends because they’re taxed at long-term capital gains rates, which is usually much lower than your ordinary-income rate. Not all dividends are qualified and the ones that aren’t will be taxed like interest.
Capital Gains (#3)
You earn capital gains from the sale of investments. This is passive in the sense that you may spend time researching companies but you don’t necessarily “work” in the company to earn. It’s also something that is lumpier in the sense that you pick and choose when you realize capital gains (or losses).
We consider capital gains as a passive income stream even though it’s so lumpy because you can turn a holding into a stream by simply selling shares from time to time. It’s not a stream in that it offers yield with no reduction in principal but it is a stream.
Royalty income is income you earn when others borrow or use your property. This could be something you purchased or something you created. An author may write a book and a publisher will print, distribute, and sell that book. The author gets a percentage of each sale as a royalty and it’s a well-understood system.
If you are not the creator of the work, you could buy the work from the creator and license it to others. For example, you could buy the music rights to a song and then license it for use to others.
With the rise of ebooks and self-publishing, I’ve known several writers who have built up a library of books for sale on Amazon that create a nice side income without day to day effort. The beauty of that type of business is that you build a following and each person who discovers one of your works is introduced to an existing library.
Rental income (#5)
When you own real estate, you can earn rental income from individuals or companies who rent the space from you. This can be residential as well as commercial property, with different rules for both.
Many years ago, this meant owning the property yourself. With the rise of crowdfunding platforms, smaller investors can own just a fraction of a property along with other investors. You can use this as a way to diversify your real estate portfolio without putting too much into one investment.
This is especially fascinating in the area of investing in farmland. Farmland consistently increases in value and offers a cashflow component that may be appealing to investors.
Business income (#6)
This one may be a little deceptive in the sense that it’s not necessarily “100% passive.” If you own a business, some portion of your business income will be passive in the sense that you aren’t personally laboring to earn every dollar the business brings in. You are building something that generates income without active work, like a website or the sale of information products.
When I started a blog, I had no idea it would become a business that earned money throughout the day – even if I was playing with my kids or sleeping.
There are others, less common income-producing assets, but those are the six types of most millionaires.
When they say “7 streams of income,” they don’t mean 7 different types. They mean 7 streams from 7 sources, even though the sources can be the same type. The idea is that you should be thinking about different ways to diversify your income streams and not relying on any one to build wealth.
How I built my streams of income
Rewind the clock to the early 2000s. I was single, but dating my future lovely wife, and working a 9-to-5 job in the defense industry. I kept my expenses low, my savings were high as a relative percentage of my income, and I was avoiding self-inflicted financial wounds like loading up on a lot of fixed expenses (cars, rent, etc).
I still had an abundance of time, since my girlfriend was still in college, and so I started a blog. The blog would be a precursor to this one in the personal finance world.
The blog would transition into a business, generate income, and I’d put much of that income away into savings. Those savings lived in a taxable brokerage account at Vanguard and invested in their low-cost index funds. I would occasionally purchase dividend stocks, especially during the housing and financial crisis, but mostly kept it in Vanguard.
I transitioned into working on the business full-time for a few years before moving on.
Throughout, I invested the profits into other areas that I felt were differentiated from my core business. Savings were put into passive sources of income and kept as cash.
My 7 streams of income (updated 2021)
Now that I’ve explained how I view building streams of income and my personal story, I’ll share with you my 7+.
I run several online businesses now (all it takes to start one is a domain, hosting, and maybe incorporation). There are two notable ones. The first is a meal plan membership site called $5 Meal Plan that I co-founded with Erin Chase of $5 Dinners. The second is the umbrella of blogs I run, including this one and Scotch Addict. They pay me ordinary income as well as qualified distributions since I’m a partner.
The bulk of my investment assets are in what we consider the “stock market,” mostly in a variety of Vanguard Index funds. I am paid interest, ordinary and qualified dividends, and will eventually be sold for capital gains. I also have some private placements that are debt and equity instruments which so far just result in interest.
To give you a sense of scale, 80% of our investable assets are in the stock market.
Real Estate Investments
Under the category of real estate, I’ve tried owning property but haven’t had much success so I tend to rely on crowdfunded real estate sites where I don’t own any property outright. It’s small investments in partnerships that own the property.
It started with three investments on the RealtyShares platform (which was shut down) and each has paid out according to schedule and only one remains (the others closed out as expected, thankfully!). I’ve looked at some others, including Fundrise and stREITwise, but for traditional real estate I’ve only used RealtyShares.
I invested in three farms through AcreTrader as well. I like farmland as a way to diversify. Finally, I’ve made hard money loans to real estate investors (it was just one individual and the loan has since closed). They’re simple loans where I am paid interest on a monthly basis.
I’ve also invested in private funds with operators I know and trust. One invests in multi-unit apartment complexes in the Phoenix, AZ area and another buys mobile home parks across the country. I view these as recession-resistant and these operators are top notch. Each fund has already started paying out dividends and one has even sold the property at a gain, beating the projected IRR, and I’ve reinvested that money into a subsequent fund.
(a quick aside about investing in real estate in various other states, it’s been a bit of a pain in the butt with filing state income taxes – one of the downsides of alternative investments)
There are so many more types of streams out there than what I’ve listed – I know a lot of people who collect rental income (from rental properties) and royalties (like from books or other creative work) – but I don’t have any of those.
To recap, my 7 streams are:
- Revenue from two internet-based businesses, this blog and a meal plan business
- Bank interest
- Interest from loans, hard money loans to an individual and crowdfunded real estate deals
- Interest from stock investments
- Capital gains from stock investments
- Ordinary and qualified dividends from stock investments
It’s more than 7 sources but in terms of types, it’s only four types – Revenue from the business, interest on loans, and dividends, and capital gains from stocks.
The key thing to note in those various streams is how few of them rely on my active participation and how they were fueled from savings. My active participation is in this blog and $5 Meal Plan. Everything else is passive, outside of routine maintenance like updating my net worth record, and none of them would be possible if I didn’t have the savings to invest.
If you were to look at my tax return for 2015 (when I originally wrote this article), here is how my AGI broke down:
- Wages – 16% (part active, part passive)
- Interest – 11% (passive)
- Dividends – 21% (passive)
- Capital Gains – 34% (passive)
- Business Income – 18% (part active, part passive)
In 2019, the AGI shifted a bit as this blog started getting more traffic and earning more income:
- Wages – 32.8% (part active, part passive)
- Interest – 2.2% (passive)
- Dividends – 6.8% (passive)
- Capital Gains – 0% (passive, though I didn’t sell anything)
- Business Income – 55.6% (part active, part passive)
(Wages, in this case, is doubled counted into business income because the business pays me a salary)
Quite a bit of our income is passive, though and those funds continue to accumulate (with occasional unrealized “paper” losses as the market moves) without my active participation.
It’s at the point where the financial benefits of active work have an increasingly smaller impact on our net worth.
This transition was one of the biggest personal challenges I faced after “retirement” – a subject I discussed in a post on What They Don’t Tell You About Retiring Early on the great Our Next Life blog. Decoupling work from pay was a huge step.
Not all passive streams are equal
There is only one stream where you bear all of the risks but reap all of the rewards – the stock market. (we can quibble over the use of absolutes but I think you get the point)
In every other case, you bear more of the risk than the rewards you potentially reap because you need to pay someone who is actively working on it. If you invest in a business, you take on a lot of risks but you don’t get all of the rewards. Before distributions to shareholders, operators will be paid.
Not only that but in almost all other cases there is the illusion of influence, which is itself a psychological and emotional cost. If you invest in a business that your friend or family member is running, you can see how things can get messy. You have thoughts on how things should be done, they have competing thoughts if things aren’t going well… we know how this story goes.
That being said, the upside to many of the other options can far exceed the stock market and that balloon payment is very appealing. In five years, I built a website from $0 to seven figures. You cannot do that with the stock market.
The cash flow, leverage, and tax benefits in other passive streams, like real estate, is also very appealing. Donald Trump took a $1 billion tax deduction a few years ago! You cannot do that with the stock market either.
Finally, there are assets that have no passive income streams but that you can create a stream using the Buy Borrow Die estate planning strategy.
What’s the point…
The point is that wealth accumulation is only possible if you can convert active work into income. The higher the rate (pay) the better.
Then avoid self-inflicted financial wounds (you can’t do much about what life throws at you) — then convert those savings into passive income sources.
One final video to cement this idea that the path to wealth is through passive income – it’s a TED talk by Thomas Piketty, author of Capital in the Twenty-First Century.
Capital in the Twenty-First Century was published in 2013, it’s very dense with a ton of data, and it focuses on wealth and income inequality.
The core idea is that, over the long term, the rate of return on capital is greater than the rate of economic growth.
This is how wealth becomes concentrated and one of the powerful reasons to save more and have your capital work for you.
If you watched the video, he goes into a discussion about shocks (about 8 minutes in) like bad investments but how they don’t matter as much if r (rate of return) is greater than g, the rate of economic growth. If r = 5% and g = 1%, then you can lose 80% (the difference) and still be ahead because the return on the remaining 20% has paced with economic growth.
This is a similar idea to my idea of financial gravity. If your savings can grow at a rate that exceeds your spending, you leave the gravitational pull and now your income is decoupled from your active work.
Now, all that said, if capital (savings) grows faster than the growth of the economy, those with savings will see their wealth grow at a faster rate than those who rely on the growth of their income. While this is not an extension of Piketty’s argument (you can’t take an idea that applies to a population and a whole economy and boil it down to the individual like this), it’s not an unreasonable conclusion to take and apply to your own life. (Piketty does talk about this on an individual level, but says it’s more impactful for billionaires vs. millionaires – though we have limited data into individuals)
If all the talk of passive income and having your money do the work for you didn’t convince you, Piketty’s work (and talk) should put the final nail in that coffin. 🙂