If you’re investing in order to make money while you sleep, you’re interested in purchasing assets that produce income. This is a worthy goal, and don’t let anyone tell you otherwise. There’s no inherent virtue in working for wages. If you don’t have to work to live, you’re financially independent. You’ve won the money game. Traditionally, people attain financial independence such that they can retire in old age. But it doesn’t have to be that way.
Most of us don’t learn in school how to become financially independent. Instead, we learn what we might need to get a job that pays wages. Learning how to become financial independent usually requires self-education.
In this article, I’m going to highlight some tried and true ways to generate income from assets you’ve purchased.
What are assets and liabilities?
Before diving in, let’s clarify definitions. Some well-recognized people in finance such as Robert Kiyosaki define assets as things that put money in your pocket. And liabilities are things that take money out of your pocket.
Dividend-paying stock? That’s an asset.
Your house? That’s a liability. (Don’t believe me? Does your house put money in your pocket every month?)
I argue elsewhere that purchasing your own primary residence can be an incredible way to boost your wealth and future passive income. But while you live in it, your house is a liability, not an asset.
If you want to stop working but continue to collect income from investments, you’ll have to build a portfolio of income generating assets.
Examples of income generating assets
Purchasing income producing assets has become simpler than ever in history. I’m going to enumerate several income producing assets and list the ease of access, return potential, and tax implications of each.
Income Asset #1: Dividend Stocks
- Ease of access: 10/10
- Return potential: 5/10
- Tax implications: 4/10
What are dividends? Profitable companies pay shareholders a premium on a regular basis from available cash. Normally, companies that are rapidly growing don’t pay hefty dividends since they are using cash to continue to expand. There are exceptions, like Apple and Nvidia, which do pay dividends.
All you need to purchase shares or even fractional shares of stock nowadays is a mobile phone, a few dollars, and a brokerage account. How do you choose a dividend paying stock? Some people choose among the dividend aristocrats, which are companies in the S&P 500 which have historically raised their dividend payouts. Others use dividend funds like VYM.
Unfortunately, the income yield from dividend stocks is medium to low. Apple (AAPL) pays a dividend of 0.61%, but the underlying stock appreciates well (290% in the last five years). On the other hand, dividend aristocrat Coca-Cola (KO) pays a dividend of 3%, and Exxon-Mobil pays 4.2%. Dividends are normally paid on a quarterly basis. In order to take home $1,000 monthly (before tax!), you’d have to own $400,000 worth of KO.
The tax treatment of dividends can be favorable if you hold them for at least 60 days before the ex dividend date. The qualified dividend tax rate depends on your income and filing status but ranges from 0-20%.
Income Asset #2: Physical Real Estate
- Ease of access: 3/10
- Return potential: 10/10
- Tax implications: 9/10
It’s no secret that real estate can create substantial wealth. Unlike other assets which may sacrifice growth for yield, real estate enjoys inherent asset appreciation in addition to dividend yield in the form of rent.
Unfortunately, it’s not as easy to buy physical properties as it is to buy stocks. Unless you have substantial cash savings to purchase with cash, most new real estate investors begin by obtaining a mortgage. In order to qualify, the investor needs a good credit score, substantial downpayment ranging from 20-30% of home value, and cash reserves. What’s more, the relatively high transaction costs make property purchase in terms of seller fees. Physical real estate is markedly less liquid compared to stocks.
The barriers to entry in real estate are lowering. Companies like Doorvest enable would-be real estate investors to purchase turn-key properties without ever setting foot in the house itself.
The return potential from real estate is massive. Unlike owning stock in Apple and Tesla, real estate investors can directly impact the asset value by improving the property and forcing appreciation. Rents, which after expenses can be considered the dividend yield, are also managed by the investor. Many real estate investors don’t even consider a property purchase a good deal unless the cash-on-cash return exceeds 10%. That’s much higher than dividend stock yield. Part of the reason this is achievable is because real estate investors use leverage, or borrowed money, which can multiply yield.
And if that’s not all, earning income from dividends is tax advantaged. The business of renting a property requires expenses such as home insurance that can be deducted against the income. But there are also phantom expenses like depreciation which can further lower the total tax bill from real estate investment income.
For these reasons, physical real estate shines as the star asset for income generation.
Income Asset #3: Municipal Bonds and Bond Funds
- Ease of access: 8/10
- Return potential: 5/10
- Tax implications: 10/10
For investors seeking tax-exempt income, municipal bonds or munis may be the answer. A municipal bond is created when cities and governments borrow money to complete projects. There are two types of munis: general obligation and revenue bonds. Most munis are revenue bonds which are guaranteed by the revenue generated by the project, for example, the toll road being built. General obligation bonds are guaranteed by the city’s funds.
You can purchase munis from your brokerage account. There’s a relatively low barrier to entry with these bonds. I use ETrade and can purchase a muni in a few clicks. You can also purchase muni funds that diversify your risk.
Like dividend stocks, the yield from bonds can be low, on the order of 3-4% currently. Unlike dividend stocks, most munis are tax exempt, even from state taxes if purchased from your home state.
Income Asset #4: REITs, Fundrise, etc
- Ease of access: 10/10
- Return potential: 6/10
- Tax implications: 5/10
Real estate investment trusts (REITs) allow everyday investors to purchase a fund of real estate investments passively. They’re accessible through brokerage accounts and pay dividends. In fact, REITs are required to pay 90% of their taxable income as dividends back to investors. One famous REIT, called Realty Income (O), delivers monthly dividends and ranks among the S&P 500’s Dividend Aristocrats with a 4% return.
Fundrise is a company that maintains its own investment fund and REITs. For investors, Fundrise offers goal-driven plans featuring income REITs and growth REITs. The minimum investment is $10. For the income-driven plans, returns are about 4.5%.
Unfortunately, dividends distributed by Fundrise and REITs do not enjoy the same tax advantages as physical real estate. Instead, the tax advantage of depreciation and other expenses is “baked in” to the dividend earned by the investor.
Should I Buy Income Generating Assets Now?
Now we’ve covered in detail some of the most commonly used income vehicles used by everyday investors. But should you invest in these assets now?
Or, to rephrase, when does it make sense to diverge from capital appreciation to income generation?
This question is most complex and nuanced for mid-career investors with a sizeable portfolio. Should they continue to heavily invest in equities with higher risk-reward profiles throughout their lives? Should they keep a proportion of their portfolio specifically in these income-generating vehicles? What proportion? And what if they plan to continue working?
These questions are less difficult for the beginning investor. Other than physical real estate, which carries significant tax advantage and capital appreciation, income vehicles should not represent a large proportion of assets invested. Instead, new investors should find ways to increase the total portfolio size by investing for growth.
The income generating assets won’t produce very much income at all until the investment is sizeable, in the hundreds of thousands of dollars. That means a lot of investing and growth before converting the assets from growth-oriented to income-oriented.
Thanks for reading.
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