Personal Finance
By the Inspired Investor team
Published May 11, 2023 • 6 Min Read
Ever hear the saying “let your money work for you?” That’s the mindset behind passive income, or earnings generated with minimal effort. While active income usually comes from a job or a business that requires, you guessed it, active participation, types of passive income include things like earnings from investments or rent from investment properties. Building out your revenue streams can be rewarding, grant you additional financial stability (or independence!) and help shape your big-picture financial plan. Let’s look at what that means.
Types of passive-income investments
Investments that can generate passive income generally fall into these categories:
Real estate. Rental income is the primary way of making passive income from real estate. That can include renting apartments or short-term accommodations. About two-thirds of Canadians are homeowners. In 2020, almost eight per cent of Canadian households declared rental income, up from seven per cent in 2008.
Business or entrepreneurship. If you have a hands-off role at a company (say, one structured as a limited partnership), there are ways to make money without directly managing the business. Selling copies of on-demand courses, art or other content online is an example of a business model that can be mostly automated after the initial creative work is done.
Fixed-income products. As the name implies, these investment vehicles are a source of fixed, or regular, income. Bonds typically net you semi-annual interest payments. Fixed-income mutual funds or ETFs (exchange-traded funds) are professionally managed and provide opportunities to diversify your account. GICs, or guaranteed investment certificates, have become more popular as higher interest rates have increased their returns.
Other income-generating securities. This category includes so-called “income stocks,” or stocks that pay dividends. Companies that pay dividends tend to be more established and well-managed — and have less volatile share prices — than those that do not.
As you might have noticed, few of the income streams listed above are truly “passive.” For example, real estate requires a degree of property and tenant management, and stocks may require planning and monitoring a portfolio. They also require up-front effort – consider the work it takes to start up a business venture versus simply signing up for an investment account online. These are important considerations when planning out a passive portfolio.
The benefits of passive income
Passive income can be appealing for many reasons. A little extra cash flow is always nice, especially if it is regular and predictable. Additional income can supplement your paycheque or retirement income, help you diversify, serve as a buffer against economic downturn or bolster your emergency fund. Plus, the often minimal effort required to generate passive income frees up time to focus on interests and other important work. Put simply, more cash flow gives you more options.
Risks of passive income
It’s important to note that passive income doesn’t mean easy money. As with all investments, returns can fluctuate with the markets. Companies are not obligated to pay dividends, interest rates can take bonds and real estate prices for a ride, and inflation can put a dent in online sales. And, depending on your source of income, different tax rules may apply.
Some of these risks can be limited through increasing your sources of passive income. As a rule of thumb, the more sources of passive income you have, the more insulated your holdings are from volatility.
How investors use passive income
With that in mind, passive income can be a powerful tool in an investor’s portfolio. Some popular investing strategies include:
Reinvestment. Reinvesting gains can help increase your earning potential over time – think expanding a business to make more sales. In an investment portfolio, reinvesting dividends from certain stocks or ETFs, or distributions from mutual funds, can buy you more units or shares that in turn pay even more returns. (And as you may know, compounding can be an amazing thing.)
Retirement. Passive income can supplement an investor’s retirement income with regular inflows to live off of and help sidestep the need to sell off assets to generate income. Some investors aim to grow their passive-income streams to replace employment income entirely, as in the Financial Independence, Retire Early (FIRE) movement.
Diversification. As part of a balanced portfolio, passive-income generating assets can provide stable growth alongside more volatile investments or assets that must be sold before you can make money. Mutual funds and ETFs are one way to help diversify your investments.
Tax-advantaged accounts. Canadians can hold certain income-generating securities in registered plans, including TFSAs (Tax-Free Savings Accounts), RRSPs (Registered Retirement Savings Plans) and FHSAs (First Home Savings Accounts). These accounts allow investors to defer or minimize the taxes they would otherwise owe on earnings from their investments.
Getting started? Get creative
There are many ways to earn passive income. Wondering how to pick one and get started? A great first step involves evaluating your income goals, risk capacity and how much work you are willing to take on.
For many, investing can be an accessible path to earning regular income. Real estate may be attractive to investors who prefer working with something they can see and feel. Or perhaps you like the idea of a side hustle? Look to your unique skills and interests for inspiration. With a bit of research, you can find a method that works best for you.
Mutual Funds are sold by Royal Mutual Funds Inc. (RMFI). There may be commissions, trailing commissions, management fees and expenses associated with mutual fund investments. Please read the Fund Facts/prospectus before investing. Mutual fund securities are not insured by the Canada Deposit Insurance Corporation. For funds other than money market funds, unit values change frequently. For money market funds, there can be no assurances that a fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in a fund will be returned to you. Past performance may not be repeated. RMFI is licensed as a financial services firm in the province of Quebec.
Financial planning services and investment advice are provided by Royal Mutual Funds Inc. (RMFI). RMFI, RBC Global Asset Management Inc., Royal Bank of Canada, Royal Trust Corporation of Canada and The Royal Trust Company are separate corporate entities which are affiliated. RMFI is licensed as a financial services firm in the province of Quebec.
This article is intended as general information only and is not to be relied upon as constituting legal, financial or other professional advice. A professional advisor should be consulted regarding your specific situation. Information presented is believed to be factual and up-to-date but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. No endorsem*nt of any third parties or their advice, opinions, information, products or services is expressly given or implied by Royal Bank of Canada or any of its affiliates.
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Passive income refers to earnings generated with minimal effort. It is a way to let your money work for you. There are various types of passive-income investments, including real estate, business or entrepreneurship, fixed-income products, and other income-generating securities [[1]].
Real estate is a popular way to generate passive income. Rental income from properties, such as apartments or short-term accommodations, can provide a steady stream of income [[1]].
Business or entrepreneurship can also generate passive income. For example, selling copies of on-demand courses, art, or other content online can be a business model that can be mostly automated after the initial creative work is done [[1]].
Fixed-income products, such as bonds, can provide regular income through semi-annual interest payments. Fixed-income mutual funds or ETFs (exchange-traded funds) are professionally managed and offer opportunities to diversify your investment portfolio. Guaranteed investment certificates (GICs) have also become popular as they offer higher interest rates [[1]].
Other income-generating securities include "income stocks" or stocks that pay dividends. These companies tend to be more established and well-managed, with less volatile share prices [[1]].
It's important to note that while these income streams are referred to as passive, they still require some degree of management and planning. For example, real estate requires property and tenant management, and stocks may require portfolio planning and monitoring. However, they generally require less effort compared to active income sources like a job or running a business [[1]].
Passive income has several benefits. It can provide additional cash flow, supplement your regular income or retirement income, help diversify your investment portfolio, serve as a buffer against economic downturns, and give you more financial options. Additionally, generating passive income requires minimal effort, allowing you to focus on other interests and important work [[1]].
However, passive income also comes with risks. Returns can fluctuate with the markets, companies are not obligated to pay dividends, interest rates can affect bond prices, and inflation can impact online sales. It's important to consider these risks and diversify your sources of passive income to mitigate volatility [[1]].
Investors use passive income in various ways. Some reinvest their gains to increase their earning potential over time. This can be done by reinvesting dividends from stocks or ETFs, or distributions from mutual funds. Reinvesting can take advantage of compounding returns [[1]].
Passive income can also be used to supplement retirement income. Some investors aim to grow their passive-income streams to replace employment income entirely, as seen in the Financial Independence, Retire Early (FIRE) movement [[1]].
Passive-income generating assets can also be part of a diversified investment portfolio. They can provide stable growth alongside more volatile investments and assets that need to be sold to generate income. Mutual funds and ETFs are popular options for diversifying investments [[1]].
In Canada, certain income-generating securities can be held in tax-advantaged accounts such as TFSAs (Tax-Free Savings Accounts), RRSPs (Registered Retirement Savings Plans), and FHSAs (First Home Savings Accounts). These accounts allow investors to defer or minimize taxes on their investment earnings [[1]].
When getting started with passive income, it's important to evaluate your income goals, risk capacity, and the amount of work you are willing to take on. Investing can be an accessible path to earning regular income, while real estate may be attractive to those who prefer tangible assets. It's also worth considering your unique skills and interests to find a method that works best for you [[1]].
In conclusion, passive income is a way to generate earnings with minimal effort. It can provide additional cash flow, supplement retirement income, diversify your investment portfolio, and offer more financial options. However, it's important to be aware of the risks and consider diversifying your sources of passive income.
