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Passive income - Learn how you can create wealth starting today

Ever wondered how your colleague at work, who earns the same salary as you, has bought a BMW while you are still driving your 5-year-old Honda City?

Chances are your colleague has utilized his or her existing salary smartly to generate passive sources of income, on the back of which the car has been bought. By generating passive income you can achieve financial freedom and flexibility through the creation of alternative sources of income that can complement your salary income. People rarely achieve their financial goals and dreams only on the back of their salaries - one needs alternative sources of income that can increase one's wealth and consumption capabilities. Here we share with you some tips on how to generate passive income.

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What is passive income?

The salary you get from work is a direct result of your efforts at work, during your active working life. Passive income, on the other hand, is income that you can generate without having to directly work for it.

For instance, if you invest a part of your salary into instruments that will earn income for you without you spending any time on it, you can create passive sources of investment income for yourself. Apart from the act of investment, you are not directly doing any active work to generate investment income. In effect, your money works for you to earn more money for no incremental effort on your part. Over time, if you have invested smartly, you can have enough money through these passive sources to make a down payment on an apartment or buy that dream car.

Even if you start small, the idea is that you should start creating passive income for your self. Through the sheer power of compounding of capital, small savings today can grow into a large amount within just a short period of 4-5 years.

What are different sources of passive income?

The following are examples of passive income:

• Rental Income: You can buy a property for investment purposes and rent it out thereby earning rental income. Often people use rental income from one property to pay for the EMI or down payment of a newer property they want to purchase


• Dividend Income: If you invest in shares or mutual funds, you might receive dividend income if the instruments pay out dividends. These can be reinvested to create other sources of income


• Interest Income: When you invest into a bank FD or buy bonds, you can get interest income. This recurring income stream can help finance part of your current consumption needs, if needed, or be saved for other goals


• Capital Gains: If you sell an asset that has appreciated in value since the time of your purchase, you can create a one-time capital gain for yourself. These proceeds can then be used to create other assets


• Windfall Gains: Some games of chance, where legal, like say buying a lottery ticket or being a legal heir to an inheritance might result in a windfall gain that has nothing to do with your efforts

When can I start earning passive income?

You can start as early as today! All you need is a regular source of salary income and the discipline of setting aside a part of this salary, even if it is a small amount, towards investment purposes before you start spending your money on your lifestyle or your living costs.

This of course might not always be easy, and depends upon the state of your personal finances and your family situation. Also, if you are just starting out your career, you might not have the flexibility to invest immediately. To add to these is the peer pressure to spend money on items of conspicuous consumption like the latest mobile phone or a cutting edge flat screen LCD TV. The choice whether to invest or not is of course yours, but please bear in mind the tradeoff in the long term - you can either consume today, or save up to consume for later.

If, however, you are in your middle age, you might not be left with much of a choice and your key goal should be to use as much of your income as possible from your remaining peak earning years to create a source of passive income, which is often the only source of funds for most people during retirement.

What is the tax impact of passive income?

Like your salary income, any passive income that you generate will also create a tax liability for you.

Depending upon the source of the income there might be different tax treatment applied. For instance, dividends from equity instruments such as stocks or equity mutual funds are tax free in the hands of the investor. However, dividends distributed by a debt or a liquid fund will be subject to a dividend distribution tax paid out by the fund.

Further, the tax treatment also depends upon the time duration that you hold an asset or an investment. If you make a gain on a capital market investment, but hold it for less than 12 months, short-term capital gains tax rules will apply. If you hold the investment for more than 12 months then long-term capital gains tax rates will be applicable. Similarly, for property the holding period that determines a short or long-term capital gain is whether you have owned the asset for more or less than 3 years. The tax rates for capital gains vary by the type of investment in question. Sometimes you might also be able to use losses from your investments to offset your taxes from other sources of income.

Whatever be the source of your passive income, you will need to declare it in your annual tax return, and pay taxes on it according to the existing tax rates and rules.

Comments

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Vinod Pandita said : 20/05/2010	Useful Post...keep guiding
Shyam Lal said : 19/05/2010	The knowledge given in this article is very valuable and important. I like it and I think it will benefit me.
PARTHAA SARATHY CHOUDHURY said : 19/05/2010	Very properly presented idea of passive income.tks for ur advice