By Dr. Jim Dahle, WCI Founder
Passive income is a wonderful thing. Who wouldn't want it? Money without work. It's like the Holy Grail and the pot at the end of the rainbow all wrapped up into one. While I have yet to actually live on passive income, the day will come eventually. Some forms of passive income are more passive than other forms, but you can learn more about all of them at Passive Income MD.
Today, I'm doing a Q&A with myself to talk about passive income, why it's important to me, and how much of it we've made.
Role of Passive Income
Q. Why is passive income important to you?
Honestly, passive income doesn't play much of a role in our lives. We mostly view it as part of our investment portfolio. Since we still have more active income than we spend—even including taxes and charity—the passive income we get at this point is all reinvested and simply raises our tax bill. We'd just as soon have an increase in the value of our investments rather than actually having the income, knowing that if we ever need the income later, we can just convert the investments into cash or into other investments that actually produce income. However, it is nice to know that stream of income is there. Perhaps somewhere subconsciously, that income has allowed us to take more risks with my career, our business, and our investments that we otherwise would not have taken.
Current Passive Income
Q. How much passive income do you have? Which of your income streams are you counting and which are you not counting as passive income?
I count regular real estate income from my passive real estate investments. On the equity investments, that's mostly rent sheltered by depreciation. Note that some of our investments (like Origin Fund III) don't make regular distributions. They send principal and earnings back in lump sums when properties are sold. I ignored all of those larger distributions in these calculations simply to make it easy to calculate, even though part of those distributions are considered taxable income. With the real estate debt investments, the income is just interest/ordinary dividends. I also count bank account interest and mutual fund dividends. I am not counting my clinical income (definitely earned), our WCI S Corp salaries (definitely earned), WCI S Corp distributions (maybe not so earned, but not particularly passive), or income from partner companies (again somewhat passive and somewhat earned). I am also not counting any capital gains.
In 2021, our passive income included the following:
- Taxable interest: $10,252
- Tax-free interest: $14,500
- Qualified dividends: $88,116
- Non-qualified dividends: $78,531
- Equity real estate income (rents): $36,841
- Income in retirement accounts and HSA: $93,828
Total: $322,068
Not counting taxes or charity, that's more than we spend. (We spent $207,000 in 2021.) If this were our only income, we could pay our taxes, maintain our lifestyle, and still give a good chunk away each year. We're not just financially independent based on wealth but also on income. Despite setting up our portfolio to maximize our risk-adjusted total return rather than to maximize income, there's still plenty of income there for our needs and wants. Since we're still working and investing, these income figures are only rising each year.
More information here:
How Our Private Real Estate Investments Performed in 2022
6 Ways Passive Income Beats Active Income
Spending Passive Income
Q. Do you actually spend any of your passive income, or is it all (at least after paying taxes) reinvested at this point?
Depends on how you look at it, I guess. Since our earned income is more than we spend, you could say we don't spend any of our passive income and reinvest it all. At the beginning of the month, however, we take all of our earned income and all of our passive income and lump it all together before determining how much is spent, paid in taxes, invested, and given away. From that perspective, we do spend some of it. If one defined our passive income more broadly to include S Corp and business partnership distributions, we certainly do spend a lot of that on taxes!
Misunderstanding Passive Income
Q. What do people most misunderstand about passive income?
Passive income is a bit of a continuum. There are some sources of income that are essentially completely passive, such as bank interest and mutual fund dividends. As you move into real estate, some income is far more passive than other income. Some additional work isn't necessarily a bad thing, as it often adds to your return, but it does mean that income is less passive. Other sources of “passive income”—such as blogs, books, and online courses—often require a lot of upfront work, and then the income comes passively after that. Even within the online entrepreneurship space, there is a continuum. An evergreen, automated course sold off a static website is much more passive than a cohorted, instructor-led course sold off of a blog. The first, I would argue, is mostly passive after the initial work. The second is not passive at all.
More information here:
How Did These Physicians Create Passive Income?
Independence Through Passive Income
Q. What do you think about doctors wanting to get some passive income so they can reduce their clinical work?
Early on in the COVID pandemic, many doctors saw decreased volumes and canceled procedures, which caused a large hit to their usual clinical physician income. As a result, they became MUCH more interested in diversifying their income streams, whether through active income streams or passive income streams. Even in more normal times, many doctors get to feeling pretty burned out and need to work less. The first thing I tell a burned-out doctor to do is to cut back to full-time!
Those docs just need to figure out whether they need to work less or whether they just need some different work. If you need to work less, you only have two choices. The first is to spend less money, and the second is passive income. Spending less money works really well because a penny saved is two pennies earned. Not reinvesting your passive income so you can spend it has the unfortunate nasty side effect of causing the portfolio (and, of course, future passive income) to grow more slowly. But it is relatively easy to shift a portfolio into assets that provide a larger percentage of the return as income. A growth stock mutual fund has a very low ratio of income to return (perhaps 0.1), but a debt real estate fund has a very high ratio (essentially 1).
If you just need different work and not less work, you have a third option: starting a side gig. Some side gigs will always be active, but many are more active up front and more passive on the back end. I think that's the route a lot of docs end up going. One of the most reliable entrepreneurial pursuits is direct real estate. You start out doing everything yourself and then gradually build systems and hire managers to follow your systems as you move along. Eventually, that income becomes very passive and may even replace your clinical income and/or fund the rest of your life.
All else being equal, more income is a good thing, and more passive income is a very good thing. I hope you found this peek into our passive income helpful. I wish you the best in building your own streams of income.
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What do you think? What role does passive income play in your life? How much passive income do you get in a year? What do you count as passive income and what as active income? Comment below!
Nice article. 3 things to consider.
Dividend from retirement account CAN only count as passive income after 59 years old if one does not want to pay 10% penalty.
Dividend from Ex US equity varied a lot annually. I did not see dividend growth year by year. I would count this as very unreliable passive income. US small cap value did better but still lacks apparently reliable dividend growth. In this way, I would ONLY count dividend from VTSAX as passive income with much more reliable growth in both capital appreciation and dividend.
I could barely count bond fund interests as passive income. Instead, I would consider interests from individual treasury or high grade corporate bond as passive income. If I bought total bond fund in 2013, it would yield a negative 1-2% annual return with inflation and with interests reinvested. On the other hand, if I bought 10 years treasury in 2013, I earn 0.5-0.8% annual return adjusted for inflation and interests reinvested. In fixed income portion, I do not want to see a lot of volatility. So most of my fixed income is in CDs and high yield saving.
There are many ways to access retirement account money without penalty before age 59 1/2 as discussed here:
https://www.whitecoatinvestor.com/how-to-get-to-your-money-before-age-59-12/
But I’m just counting INCOME (not return) from investments for this post.
Sure, dividends vary. But you can certainly count it retrospectively. If you wanted to somehow project future income, I agree you need to be more careful. But I don’t need to be careful at all about past passive income. It is what it was.
Again, we’re counting bond income, not bond returns for this post. I agree that return matters far more.
You can count income any way you please I suppose, but I don’t see why your unusual method should be generalized to everyone instead of the far more common method of, you know, actually counting income.
Question I’ve been meaning to ask you: In a growing taxable brokerage account, we’ve seen our dividend earnings grow year over year. To some extent, interest earnings too now that yields are higher. Currently, we have our brokerage investments set to reinvest all dividends. In 2022, we had a noticeable tax burden associated with those dividend earnings. How do you go about planning to pay the taxes on that each year? Do you reinvest then pay taxes from cash flow, save up for it from other sources throughout the year, or perhaps even initially set dividends aside while figuring out the tax impact and reinvest the remainder later?
Just wondering how you manage it, as it seems like you have a much bigger tax impact from your dividends than we do. Thanks!
I don’t reinvest dividends or interest in taxable automatically. I do reinvest them manually once a month with the monthly investment amount. So perhaps one month I get dividends from TSM, TISM, SV, REITs, bonds etc. Then I combine those with whatever I can save out of my earned income and then perhaps it all goes back into TIPS that month. Or VTI the next month. Whatever has been lagging lately to get it back toward the set percentages.
Not reinvesting automatically not only helps me rebalance, but it limits the number of tax lots to keep track of and deal with over time.
We have always been able to pay taxes from cash flow rather than the dividends themselves, but there will come a time that is not the case I suppose when the earned income goes away.
Regarding addressing tax consequence of dividends, let me offer you an alternative to not reinvesting monthly. Letting dividends reinvest automatically and then harvesting quarterly. Results are the same.
What Jim suggested is a great idea if you are up for the monthly review and rebalancing. Some may not be able to keep up with the monthly intervention and money will end up sitting in money market for months earning pittance, a gift to the brokerage but not to the owner.
Alternatively, one can let the dividends reinvest as part of dollar cost averaging. This is to let your investments proliferate passively. As the brokerage keeps track of tax lots, I don’t worry much with the bookkeeping. Every quarter I sell enough shares to prepay the estimated quarterly tax – you can wait until Tax Day to pay all of the tax on the annual dividend income, but you will incur a large bill including an extra underpayment penalty from IRS which is unpleasant.
As for what to sell, I look through and sell lots that are ripe for harvesting and with minimal impact on capital gains – think of using tax loss harvesting or selling lots with no cap gains.
This method assumes you pay no/low commission for transactions and that you are very happy with the investments you have. Otherwise, why reinvest?
BTW, if you want to pursue this approach, your 2 chances left for 2023 prepayments are due on Sept 15 ’23 and Jan 16 ’24.
Not sure I’d call it a pittance right now with Federal MMF paying 5.27%. It’s been a long time since the “penalty” for sitting on cash has been so minimal.
I dislike selling shares for anything as it triggers taxable capital gains, and often short term capital gains if you’re doing it frequently. While it would be nice to tax loss harvest, I don’t have a single harvestable loss and haven’t for most of the year.
5.25% MMF ARR is very attractive and enviable. Unfortunately, that is not what comes with MMF in all large brokerage firms as some average ARR of 3.8%. There are opportunities to earn 2X that in the equity market and so MMF yield of 3.8% is not a winner.
Underpayment penalty for 2023 will be at least 7%. If the annual dividend tax owed is $50K+, the estimated penalty of $3700 is unwarranted. The quarterly rebalancing to make the prepayments is also not to be underestimated as this quarterly exercise flows nicely with the distribution cycle of the equity market as well as stock prices.
The capital gain tax concern is a complex scheme to unfold here. When handled well, concerns with capital gain taxes should not exist in a matured portfolio.
So numerous methods exist for different investors at different stages of investing.
I guess now you know why my money is at Vanguard. Fantastic MMF and bond funds. Great index funds. Low costs.
We reinvest distributions automatically because it is automatic. Maybe I am busy and go for weeks without checking balances. Maybe I don’t have time to invest manually. With automatic investment, it just happens with no attention on my part.
It also means that my, say, VTI performance matches VTI.
But I do not understand the fixation on income. We invest for total return, which includes capital gains. Hopefully unrealized capital gains. When we retire and start taking RMDs, I will not care whether the money came from dividends or from capital gains.
We do not plan to spend the income or principal of our taxable accounts, but if we did, we would simply sell what was needed to make ends meet.
With near zero trading costs and lower taxes on capital gains and qualified dividends seeking out “income” can be a bad tax strategy.
Agreed.