The goal of almost any successful long-term investment portfolio eventually concludes with the desire to generate passive income. In simple terms, passive income is cash that flows into your bank account whether or not you get out of bed in the morning. Some common sources of passive income are dividends from stocks, interest from bonds, rents from real estate, royalties from unit trusts, distributions from master limited partnerships, payments from annuities, and licensing income from intellectual property.
When you add a source of passive income to your portfolio, you should look for four traits in most situations:
- Safety of the passive income stream
- Growth in the amount of passive income generated each year
- Diversification of the underlying assets that are responsible for churning out the passive income
- Tax consequences of each source of passive income
Let's take a look at each of these items individually.
1. Safety of the Passive Income Stream
When it comes to collecting checks in the mail or seeing direct deposits added to your bank statement, safety should be your number one priority. You want to make sure that if you own a security, property, or other asset, it is going to continue generating greenbacks for you to spend, give to charity, reinvest, or save. The last thing you want is to wake up one morning to find that money you expected is not there.
2. Growth in the Amount of Passive Income Generated Each Year
A truly great investment becomes valuable over time because the underlying business or property is of such high quality that management is able to raise prices faster than the rate of inflation. You do not want to lose purchasing power. Take an example like The Coca-Cola Company. If you bought shares back in the 1970's, and spent your dividend income over the past 40+ years so that none of that money had been reinvested, you would still be generating far more annual dividend income than you were back when you began cashing those checks. That is because the business itself has grown, profits have expanded, and each share now is entitled to a bigger pile of earnings.
3. Diversification of the Underlying Assets That Are Responsible for Churning Out the Passive Income
You know that old saying, "don't keep all your eggs in one basket"? Take that advice seriously. If you rely on your portfolio for income, all that counts is the total dollars that are showing up each year. All else equal, it is better for you to generate $50,000 per year from 50 different investments, each of which gives you $1,000, than it is for you to hold 2 investments, each of which earns $25,000. In the latter case, a problem with one of the two investments would lead to a catastrophic cut in your standard of living. That is not acceptable at the stage in the game when you are in harvest mode, reaping the rewards of a lifetime of saving money.
4. Tax Consequences of Each Source of Passive Income
Taxes matter. Taxes matter a lot. It doesn't really do you any good to focus on the amount of money you earn in isolation because the only thing that really counts is the amount of money you keep. Not all passive income dollars are equal. A dividend is currently taxed at only 15%, while distributions from a master limited partnership might be treated as a return of capital and owe little, if any taxes, for the first few years. A traditional corporate bond could be as taxed as high as 41% in a worst-case scenario, while a tax-free municipal bond could escape taxation entirely. Complicating matters further, assets held in certain types of accounts, such as a Roth IRA, might not be subject to any taxes unless you fall into a trap, such as the Unrelated Business Taxable Income trigger, or UBTI.
When you put together your list of cash generating assets, make sure you calculate the actual net, after-tax proceeds you receive each year. Sometimes, you can increase your standard of living significantly by shifting the types of holdings you maintain or engaging in a technique called asset positioning. It's free money sitting on the table for you to take. There is no reason not to put in the extra work and end up a little bit richer.
Make Sure You Revisit Your Investment Portfolio At Least Once a Year
Set a specific time at least once every year - such as the second Tuesday in February or the day after Thanksgiving - and go through each of your investments. Analyze them. Make sure they still offer the four things we talked about - safety, growth, diversification, and good after-tax results. It's a small price to pay for peace of mind.