Wallet Hacks

7 income streams of millionaires: an open discussion of passive income

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?

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. J Money took this same idea and started at $100k, which took him 7yrs 11mos. Each of the next $100k milestones took close to 18 months each to reach.

The more money you have, the more money you'll get.

The rich do get richer – here's the playbook.

Let's talk about making money

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 still work, 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.

For example, my friend Paula shares monthly real estate investment reports. In March 2016, she profited $7,461 on less than six hours of work. In July, she spent three weeks and $13,648 renovating a rental to increase yearly income by $4,740. Rental income is passive but it requires work.

How do you accumulate wealth?

Here's the next key to the puzzle.

The key to accumulating wealth is uncomplicated:

  1. Sell your time for money,
  2. Spend less than you earn,
  3. 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 probably only have 2.21 billion heartbeats. At 60 beats per minute, that's a little over 70 years. Each beat matters.

There's actually 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 a 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 challenge to navigate but it is also very freeing.

Start with Active, Build Up Passive

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:

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 immediately, whereas earning more is often a long term play, like building sources of passive income. So you cut what you can now (ie. cut your cable) and secure immediate savings while you build up your passive sources (ie. 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 are able to 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 to begin with, you may pay zero taxed on capital gains. If you are in a high tax bracket, it's only 15% – far lower than ordinary income tax rates.

About those passive streams…

I think of each passive stream as falling into one of two categories:

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 types of (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):

  1. Interest – from a variety of loans, either to individuals (peer to peer lending or private notes) or companies (bonds, notes)
  2. Dividends – from investments, partnerships
  3. Capital gains – from the sale of investments
  4. Royalties – from products you sell or license
  5. Rental income – from real estate
  6. Business income – which may or may not be passive but the idea is you build something that generates income without active work, like a website or the sale of information products

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.

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.

All 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 streams of income

Now that I've explain 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 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.

I've also made hard money loans to real estate investors (just one individual). They're simple loans where I am paid interest on a monthly basis.

I've also recently dabble in crowdfunded real estate sites with a small investment in a property on the RealtyShares platform. I've looked at some others, including Fundrise and PeerStreet, but my money has only been committed to RealtyShares.

There are so many more streams than what I've listed – I know a lot of people who collect rental income and royalties (like from books or other creative work) – but I don't have any of those.

The key thing to note in those various streams is how few of them rely on my active participation on a daily basis and how they are fueled from savings. My active participation is in the blogs and $5 Meal Plan. Everything 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 it.

If you were to look at my tax return for 2015, here is how my AGI broke down:

The vast majority of our income is passive and those funds continue to accumulate (with occasional unrealized “paper” losses as the market moves) without my active participation.

In fact, it's at the point where the financial benefits of active work no longer have an impact on our net worth. Last year's wages divided by our net worth was less than 1%.

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 active. If you invest in a business, you take on a lot of risk 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.

What's the point…

The point is that wealth accumulation is only possible if you are able to 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 really 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 own 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. 🙂