By Dr. James M. Dahle, WCI Founder
One of the major premises of this blog is that a physician need not do anything special in order to reach financial independence and “live the good life”. She doesn't need a side gig. She doesn't need fancy investments. She doesn't need a financial advisor. Simply living like a resident for 2-5 years after residency and then continuing to put 20% of your gross income into a reasonable, simple investing plan should enable any physician to meet all their reasonable financial goals and achieve financial freedom within the span of a typical career.
That said, from time to time I enjoy writing about some of the other ways to build wealth. Fancy investments are interesting and sometimes have different risks and rewards when compared with a basic index fund portfolio. Entrepreneurship has changed my life and that of many other physicians. Early financial independence opens all kinds of other doorways in your life. So in a blog about all things financial for high earners, from time to time I write about these other subjects. Today is one of those days.
Active Income vs. Passive Income
When comparing the two sources of income, passive income beats the pants off of active income in almost every respect. Here are six reasons why:
#1 No Payroll Taxes (Maybe)
The term payroll taxes refers to Social Security, Medicare Tax, and Additional Medicare Tax. These taxes only apply to earned income, not passive income. You don't pay these taxes on rental income, dividends, interest, or capital gains. Social Security tax (6.2% employee, 6.2% employer, 12.4% total) only applies on the first $142,800 [2021] of earned income. Medicare tax (1.45% employee, 1.45% employer, 2.9% total) applies to all earned income. Additional Medicare Tax (0.9%) applies to all earned income above $200,000 ($250,000 Married Filing Jointly).
Unfortunately, The Patient Protection Affordable Care Act (PPACA) not only added that 0.9% Additional Medicare Tax, it also added a 3.8% Net Investment Income tax on unearned (passive) income above $200,000 ($250,000 MFJ). So high earners are going to pay 3.8% (2.9% Medicare tax plus 0.9% Additional Medicare Tax or 3.8% Net Investment Income Tax) on both earned and unearned income.
Prior to PPACA, this was a huge advantage of passive income over active income, but now that only applies to lower earners. High earners have already maxed out their Social Security taxes and will pay the same 3.8% either way. The benefit to cost ratio of payroll taxes can be even lower for a dual-income couple, so passive income can be an even better deal for them, but again, this doesn't really apply once both spouses are each making more than the Social Security Wage Limit.
Payroll taxes are primarily Social Security and Medicare taxes. All earned income is subject to Medicare tax. That's 2.9% (including the employer portion), plus the extra PPACA tax of 0.9% for a high earner.
#2 Lower Tax Scale
The ordinary income tax brackets are dramatically different from the qualified dividends/capital gains tax scale. Take a look:
Which rate do you want to pay at? 12% or 0%? 35% or 15%? 37% or 20%? Seems like a pretty easy decision to me.
#3 Depreciation
Real estate investors don't get to enjoy that lower qualified dividends rate on their passive income, but they get something almost as good—depreciation. Now I'm of the school of thought that you get to take depreciation mostly because buildings and appliances really do depreciate, but even so, it gets pretty favorable tax treatment, particularly for a high earner. Depreciating your property allows you to defer taxes on them until you sell the property and the depreciation is recaptured. That deferral by itself is very useful, particularly if it allows you to defer it until such a time as you are in a lower bracket. You can also avoid that recapture completely by doing 1031 exchanges from one property to another until the owner dies and gets that step-up in basis at death. But wait, there's more. That recapture tax rate maxes out at 25%, even if you're in the 37% tax bracket.
#4 Passive Income Works When You Aren't
Let's move away from the tax advantages of passive income over earned income now, although I think you've gotten the message—people with high earned income are the suckers in our progressive, capitalistic tax system.
One of the biggest advantages of passive income is that it works when you aren't working. The more passive the income, the less work that is involved at all. This appeals to my inherent laziness. But consider a high-powered surgeon. Sure, her hourly rate, while she is operating, is astronomical. But as soon as she walks out of the OR, that income stream stops until she scrubs in again. Vacation? Not only is there no income stream, but there is likely a negative one due to overhead. When a passive earner is on vacation, that income stream, small as it may be in comparison to the surgeon, keeps right on working. Interest works both ways and as my kids know, interest should be something you get, not something you pay. As J. Reuben Clark said nearly a century ago:
“Interest never sleeps nor sickens nor dies; it never goes to the hospital; it works on Sundays and holidays; it never takes a vacation; it never visits nor travels; it takes no pleasure; it is never laid off work nor discharged from employment; it never works on reduced hours; it never has short crops nor droughts; it never pays taxes; it buys no food; it wears no clothes; it is unhoused and without home and so has no repairs, no replacements, no shingling, plumbing, painting, or whitewashing; it has neither wife, children, father, mother, nor kinfolk to watch over and care for; it has no expense of living; it has neither weddings nor births nor deaths; it has no love, no sympathy; it is as hard and soulless as a granite cliff. Once in debt, interest is your companion every minute of the day and night; you cannot shun it or slip away from it; you cannot dismiss it; it yields neither to entreaties, demands, or orders; and whenever you get in its way or cross its course or fail to meet its demands, it crushes you.”
I want interest (and other sources of passive income) working FOR me, not AGAINST me.
#5 Capitalism
While reading a very interesting book recently about the conquest of the Northwestern Territory (it's Ohio, not Oregon for those of you who aren't history buffs) I realized that the founding fathers of the US were all unabashed capitalists. Washington, Hamilton, etc. all held title to huge tracts of land West of the Appalachians that they had been speculating in for decades. Forming the US Army (a standing army was a big deal to a people who at the time equated a standing army with tyranny) and conquering the Iroquois was, in at least some respects, about profiting on their investments. While WCI readers probably don't have any plans to conquer other nations, the real point of all this financial stuff we talk about on this blog is to turn yourself into a capitalist as quickly as possible. While capitalism has its issues, it's still the best economic system we've found yet.
Capitalism basically means passive income. It means making your money work as hard as you do, or better yet, did.
#6 Passive Income Is Scalable
Kayaking in Ketchikan, AK
Imagine making more money while on an Alaska cruise than in your practice all month–that's the power of passive income
Another great aspect of passive income is that it is often completely scalable. Consider my first book. If I sell 10 copies of it, I might get $100. If I sell 100 copies of it, I might get $1,000. How much additional work did it take for me to sell those extra 90 books? Zero. And there's nothing keeping me from selling 1,000 or even 10,000 copies of the book. A website is the same way. No limit on the eyeballs that can view it (as long as I keep upgrading the hosting plan!) Shares of stock are the same way. Owning 100,000 shares is no more work than owning 10 shares. If you're a real estate investor, once you get your “system” in place (agent, insurance guy, attorney, accountant, property manager, repairman, etc.), it may not take you much more work at all to own 10 properties than to own one. Maybe you do speaking gigs and charge $50 a head. Is it any more work to speak to 500 instead of 50? Not really. Leveraging your money is great, but leveraging your time through scalability is even better.
The Only Negative of Passive Income
In fact, as I laid in bed one morning coming up with this post, I could really only think of one aspect of passive income that is worse than earned income. If you are a high earner, you can't deduct real estate losses against your earned income unless you qualify as a “real estate professional“, which basically means you spend > 750 hours a year doing it. That's it. The rest of the time, passive beats active.
What do you think? What sources of passive income do you have? Which ones are you trying to develop? Do you think it's fair that capital gets better tax treatment than labor? Why or why not? Comment below!
I love my passive income. When you achieve enough of it the decision to start slowing down is easy. My passive income is plain vanilla. It is just coming from stocks and muni bonds. Some complain about the tax drag of income in a taxable account but I look at it as covering my living expenses in retirement. Interestingly I have never invested in “income” producing funds etc. If you save enough your portfolio will pay you more than enough without doing anything exotic.
Off topic but Hatton, are you subscribing to tax efficient placement of funds as outlined at boggleheads? WCI has had a good contrarian argument for bond funds in taxable when rate environment is low.
I’m holding short term bond funds in taxable at this point to prevent restricting tax advantages space…
LOVE tax free munis Buy GO over REvenue bonds when you can
Thanks for this article, WCI!
What about getting hit with AMT (Alternative Minimum Tax) in cases your passive income / capital gains are too high? I’m not that familiar with the details of AMT, but I got hit with AMT one time due to an “exercise and hold” of ISOs (stock options). My CPA explained it’s another method of calculating my tax liability, and in cases I gain too much capital gains, the IRS may treat and tax them as ordinary income.
Well, if the house bill passes in its current form you won’t have to worry about AMT on your 2018 taxes.
Yep, looking forward to it!!
Yes,
Passive and portfolio income is the way to go. I learned that as a teenager. I made a computer game and wrote an article about it. I worked for a few days one summer but then had royalties flowing in for years. I have fostered those income streams ever since.
The PPACA Medicare tax is a dangerous tax IMHO. It is an entirely new kind of tax. It is small and in jeopardy of going away but I predict it won’t. If it goes away it won’t be for long and it will grow over time – like most taxes. 3.8% is a starting point. This one has the added political appeal of “taxing the rich” and “unearned income” that makes it more palatable to the electorate.
This article dovetails nicely with your recent podcast “How to Get Rich Quick.” I would argue that you are not “inherently lazy.” My reasoning is that you are working at 1.5 FTE when you are F.I. I would confirm that once you have the real estate team in place, it is passive as you have suggested. The “work” with passive income comes at the beginning. Whether that be your book, website development, studying the real estate team, or learning finance. Lastly, I like Rockefeller’s quote on passive income. Perhaps you could add it to your quote bank. Here it is: “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” There is no doubt, it is much easier to earn money on your money than work a job and earn money.
I read this as I am getting ready for work. Being a physician in modern days is very much being a widget turner. You gotta work to produce.
Even now, with the recent upheaval in life with the fires, I wish I had more passive income so I could go part time. Instead of passive income I may use the other powerful tool in finance, spending less, to allow my transition to 80’or 90% work.
This is motivating me to write a book, buy real estate, and grow my blog!
Sounds like a plan.
I’m going down to three days a week. I’m FI, so why kill myself?
Besides all the cool kids are doing it (PoF, WCI, PassiveIncomeMD, TheHappyPhilosopher, etc.)
This shouldn’t be a surprise. I mean, when I speak to groups and ask how many docs in the room would cut their hours/shifts/call etc if their finances allow it and they all raise their hand. So taking a group of docs who not only have their financial ducks in a row, but also have a side income and pursuit already, why would they be working full-time?
Good article, but a basic definition and boundaries and a little elaboration of “passive income” would have been useful for me.
We’ll try to do more posts on this topic.
Another great post! I’m starting to realize the key to freedom is increasing the passive types of income to reduce the active income we require to live.
Vivek
Don’t forget the value of reducing what you require to live by paying off debt and watching expenses. The combination can be very powerful.
This is why we can retire in our 40s. we currently have four streams of income (my salary, husband salary, husband pension and our passive portfolio income which is outside of all our employer retirement accounts). our passive portfolio income is surpassed what most people are aiming for their retirement portfolios. And we don’t sell anything…this is just our dividend income annually. Passive income is the key to flexibility. No employer necessary.
I’m a fan of passive income, but have come to realize there’s no secret way to obtain it. All sources of passive income require a very active component up front.
To obtain passive income from investments, you need to actively earn the money to purchase those funds.
To obtain passive income from real estate, you not only need the money, but also need to do your due diligence on the property, and either directly manage the details or hire a team to do so.
To obtain passive income from a book, you need to have the skills to write, edit, publish, and promote a book (or hire a team to do everything after the writing).
There are certainly advantages to these types of income as outlined above, but you can’t create passive income streams without some combination of money, knowledge, and skill.
Best,
-PoF
It turns out making money blogging isn’t so passive, is it? It’s funny that that is one of the reasons I started this blog and now I sometimes put in way more time on it than I do my practice! Some of the income from it is passive, but lots of it isn’t and even the passive stuff took a lot of work up front.
I just placed Autumn of the Black Snake on hold. For another good exploration/capitalism story, check out Astoria by Peter Stark.
“If you are a high earner, you can’t deduct real estate losses against your earned income unless you qualify as a “real estate professional,” which basically means you spend > 750 hours a year doing it.”
One additional important qualification for being a real estate professional. Those 750 hours must be the majority of your work efforts. So someone with self-employment or W-2 employment hours >= those 750-+ hours in your real estate effort is not a real estate professional.
Good point.
This is not really that much of a negative if you set your properties up for positive cash flow. In that case you get your full depreciation and all your deductions; you just bring in more cash than the deductions offset. I know, some real estate investors are all about the tax break. But back to your point: passive income is hard to beat.
Role of “real estate professional” can be well played by a non-working or stay-at-home spouse. If you’ve got one who’s willing of course. 🙂 Under current tax law, with a spouse/real estate professional materially participating in the rental property activities, the 3.8% Medicare tax (discussed in Section 1) can be entirely avoided. So, while there is a bit of burden in meeting the requirements, this could be a great play for a Doc and a real estate professional spouse who want to take unlimited real estate losses against regular earned income AND shelter any gains from the additional 3.8% tax.
I’m not sure “non-working” or “stay at home” is a good description of someone who is working 750+ hours a year. I agree it’s a good combination of careers though.
Yes, I meant that the non-working spouse would have to be wiling to become a working real estate professional – which certainly may not be an ideal solution for every couple in every circumstance. But, I was able to raise our kids while managing our rental properties as a licensed real estate professional and was always happy for the bumped-up tax benefits. No doubt, though, I was working!
one point on depreciation recapture –
most can avoid it: ” If you sold this property for a profit and it was your primary residence for at least 2 of the
last 5 years, you may qualify for the capital gains tax exclusion. This instruction will walk you through reporting this sale in the TurboTax program.”
on the comments about wanting the new tax bill:
to pass, am just curious if that is the opinion of the WCI? not all your friends and family make money through passive or pass-through companies like a doctor’s office. just wanting a break for your immediate family is not a great quality. not wrong but certainly not right.
and on a more cerebral note (less heart, emotion) on the new bill:
if passed before 2018 ho likely will it really be so simple that we can fill this out on one piece of paper? because if not we won;t be able to use a turbo tax in time or some other software. i wonder what the employment rate hit will be on that (rhetorical question)?
I hope you remember me for my good qualities and not my bad ones because I have plenty of both. As far as the tax bill, I’ll have a podcast coming up on it but probably won’t do a post until it’s law and probably not until well into the new year. I’m sure I’ll offend all of my listeners with the podcast and the post, both those who think the tax system should be more progressive and those who think it should be less progressive.
I hate this thing about the post cards. Who cares? >90% of taxes are done electronically. It will be simple if there are just less rules periods.
Passive income is definitely the goal and I think you hit it on the head with the point about upfront work. That actually coincides well with most physician careers. Work hard like a resident and spend like a resident to build up an investment portfolio right away while you are young and full of piss and vinegar. It then has time to grow and be there for you as you need or want to slow down because of aging or kids etc. Plant the seeds early and then live off the crops.
I am a big fan of passive income and I’m always looking for more diversified sources of it. The goal is to convert more of the earned income into passive income; trading money for time instead of time for money.
Currently, I invest in real estate with a single family rental and in commercial real estate through syndication. It’s not passive in terms of work effort. I still have to do a lot of due diligence.
A blog is definitely not passive as I’m starting to find out.
MD,
Yes, blogging is more like a job. And one that doesn’t pay much. At least in the beginning. And never pays well to many. At any rate, I hope you keep at it. I love your name and logo. I’m a little jealous I didn’t think of that.
wealthy doc is a good name too
Thanks Wealthy Doc. I am a fan. I was a bit surprised my domain name was still available.
I love that you even have to worry about that.
Hey! New physician financial blogger. Welcome to the blogosphere. I think that’s four in the last ten days! I hope you enjoy the journey.
Thank you WCI. I used to post comments under the name Radcrowd. Now with a new identity. Blogging is a lot of work for sure, but it’s a creative outlet for me and I’m enjoying it so far.
Anybody care to comment on the pros and cons of owning your own doctor office versus renting?
The real value of a building lies in the tenant. If you’re the tenant and you’re a good tenant, you might as well be the owner, otherwise, you’re giving that benefit away to someone else. A few years back we bought most of our buildings from other owners after renting from them for many years. Our approach to the building owners was, “We want to own our own offices, we are willing to pay you a fair price for the building, but if you won’t sell, we’ll buy somewhere else and move. 4/5 sold to us, the one that wouldn’t sell, we decided to buy a new office building and moved. Owning your own office is typically a very safe and very good investment if bought at a fair market value and assuming you are planning on staying put at least 5+ years. If you are trying to buy the office from your current landlord, I think a fair price is somewhere between the value of a vacant office building and the value of a stable physician occupied office with a long-term lease.
Stevie,
I agree 100 percent. Physician ownership of their own buildings is one of the best investments you can make. I don’t see this strategy utilized enough. It is similar to a physician owning their own house. Over long periods of time it makes a lot of sense. No brainer. For large groups, setting it up as a limited partnership makes the most sense.
PCM
Of course, over the long run the profits overcome the transaction costs. I mean, in the long run, rent (or at least rent + appreciation) HAS to be higher than the expenses of operating the property, otherwise there is no profit for the landlord.
If you own your own building there are multiple benefits. You can raise the rent when you want (within a fair market range), you can have other tenants, and there are tax benefits to being your own landlord. We did this in my private practice and it worked out very well for us. I agree with PCM LLC.
I find it frustrating that medicine frowns on us to make money through side hustles and passive income. The very few doctors I know who make money on the side keep it super secret.
there is a lot to learn on these forums, but the education is not always specific for an individual doctor in a certain community. The classic example is HCOL vs LCOL financial planning
If your own doctors in your community talked amongst themselves, then each doctor in that setting could better prepare him/herself financially.
Great post. Fortunately I learned pretty early on that our whole tax system is set up to provide greater advantages to those earning passive income. Meanwhile, the majority of the workers in the country continue to trade their precious time for a paycheck, and then get screwed through additional taxation on that money. I’m still working a 9-5, but my passive income grows with every month and I’m always looking to build more streams of passive income. You never know when one of those little streams will turn into a raging river and start really providing massive amounts of cash!
I’m not sure they’re screwed. They’re playing by the same rules as the rest of us. We can all become a capitalist just like you and I are doing. In fact, that’s really the goal for most of us- get to a position where our capital can support us. If they have a particularly low income, they’re not paying income taxes anyway (see famous 47% comment which as near as I can tell was true of federal income taxes and will continue to be true, although perhaps with a slightly different number, under the proposed House plan.)
Yawn.
This type of post gets a run on every financial blog with precious little detail. Reminds me of Madden – team that scores the most points, possibly, likely, almost, wins the game.
Truth is passive income is not easy and the boglehead style investing requires YEARS of brute force savings to make a $ throw off machine. This is reliable way to generate income, it will just take time.
Easy to say – hey look passive income rocks – ermahgerd!!! Hard to implement.
As a solid example – no offense to the blogger – passiveincomemd talks about network marketing but I haven’t seen any details. Yea. Thanks.
Lots of entrepreneurship isn’t reproducible.
It’s not a list of steps:
1) Do this
2) Then do this
3) Then do this exactly like this
and you’ll be successful. It just doesn’t work like that. You have to create your own path.
I can’t tell you how to write a book that will sell enough copies to be worth your while and provide a passive income stream. I can tell you what I did. You can read the book. I can give you a few tips, but there is no formula.
Same with a real estate property. You can’t buy the same one I bought. You’ve got to do a variation on the theme.
If you can’t figure that out, then there is always the get-rich-slowly plan of carving out a significant portion of your income and investing it in index funds mostly inside retirement accounts. That works just fine, but may not be the fastest road to Dublin for a talented/lucky entrepreneur.
No offense to the commenter, but you sound like a Complete_Newbie. You are correct that it takes hard work and patience to successfully invest and generate passive income, so do you really expect financial blog posts to provide you with specific deals or no-fail investment opportunities that you can jump on today? And if they do, they are likely just bait-and-switch sales schemes to induce you to pay for coaching or mentoring. You have to do your own leg-work and fact-finding and accept the level of risk that comes with the territory. Solid, free financial advice (like this blog) is pretty awesome and maybe you should take a look at your attitude when you wonder what is standing in the way of your passive income goals.
Nice. And you sounds like a blogger. Oh hey look, I actually clicked on your link – I’m sure you got payed.
I already have passive income from RE and other ventures, thank you very much.
And yes, if someone mentions network marketing or this or that then I do expect them to atleast post about what, how, etc not just mention it in the passing.
TBH specific details would help, why not, you got something to hide?
The more I deal with ungrateful patients and have to be away from my family due to work, the more I become a huge fan of passive income. Every 6 months when I get a check for my UpToDate sections I worked on 4-5 years ago that only require periodic minor updates, I’m always reminded how nice passive income is. Rental properties are great too, but I completely agree that you must do your homework. There are a lot of bad rental properties that will not only fail to provide passive income, but can cost a great deal out of your own pocket.
How did you get into writing UTD posts?
My chairman asked me if I was interested, as apparently he was approached with the opportunity. He passed it on to me. I didn’t know at the time writers got paid for it. I just assumed like most everything else in academic medicine that you do the job and assume it’s free labor 🙂
Great argument for passive income but want more meat on the bone on “passive income” information. We all feel screwed by the progressive tax system. Most of us probably think our dividends and cap gains are passive. True, but the real wealth, sans ceiling, resides within more risky ventures like entrepreneurship and real estate. While appealing, I’m too busy for all that at the level I need to be for success. It took me 2 years (starting with your blog) of reading financial books and blogs before I was ready to DIY invest. Several years, 2 kids and a slamming practice later, I just don’t have the time to read up on other passive avenues. Plus, I’m pretty content with my dividend and cap gains (while they last) and would rather see patients than take a call about a rental house. Maybe when the kids grow up a bit and I scale my practice back, your ideas will fall in more fertile soil. Until then, I look forward to future posts and comments.