Investments come in many forms. Some are designed to help with long-term savings for big life goals, such as buying a home or retiring early. Others are investments that can add to your income in the short term in what is known as income investing.
At Addition Financial, we consider it our mission to inform and educate our members about how to make the most of their money. If you’d like a way to add to your income with investments, then income investing might be the answer for you. What is income investing? Keep reading to learn about it and about 10 assets that can help you earn passive income, plus information about how income investing can impact your taxes.
What is Income Investing?
Income investing is investing that’s done for the purposes of generating passive income for the investor. Some types of income-generating investments may also be part of a long-term investment strategy for retirement, but the portfolio itself is structured in such a way that it generates regular income for the owner. The term passive income refers to income that you earn without regular daily effort, which puts it in direct contrast to the active income you may earn from your employer.
Investment income may come from a variety of sources, including dividends, mature bonds, and even real estate. It’s up to the individual investor, together with their financial advisor if they have one, to diversify their income investment portfolio to maximize their income.
10 Assets That Generate Passive Income
As we noted above, there are many options if you want to structure your investment portfolio to earn passive income. Some are riskier than others. Here are 10 assets to consider if you want to use your investments to generate income.
#1: Dividend Stocks
Dividend stocks are stocks that redistribute some of the company’s holdings to stockholders, often on a quarterly basis. In some cases, dividends may increase over time, giving you a growing amount of passive income if you hold onto your stock.
Some investors buy dividend stocks with the intention of adding to their income while others may choose to reinvest their dividends. If you wanted to split the difference, you could take a hybrid approach and use 50% of your dividend payments as income and reinvest the other half to increase your dividends down the line.
#2: Dividend Exchange-Traded Funds and Index Funds
Dividend exchange traded funds (ETFs) and index funds have the same benefits as dividend stocks with the added benefit of portfolio diversification. If you invest in a dividend ETF or index fund, you’ll be invested in an array of dividend-paying stocks whose overall performance should mimic the market. The Vanguard Dividend Appreciation ETF is an example.
If you want to manage your risk while still collecting dividends, choosing a dividend-paying index fund or ETF can be a good decision.
#3: Government Bonds
Government bonds represent a low-risk form of investing that can help you earn money by loaning money to the US government on a short-term basis.
Some government bonds are indexed to inflation which can make them a very safe investment if you want to protect your money. You’ll need to keep the bond until it reaches maturity to get a meaningful payout.
#4: Corporate Bonds
Corporate bonds work in much the same way as government bonds except they’re issued by private corporations instead of the federal government. If you buy a corporate bond, you will have the potential of earning a profit when the bond reaches maturity.
The other big difference between government bonds and corporate bonds is that corporate bonds carry more risk than government bonds. On the flip side, they typically pay a higher return than government bonds to balance that risk.
#5: Real Estate
Buying real estate is one of the most popular and most lucrative types of income investing. Real estate can generate reliable income in the form of rent and also offers some significant tax benefits to the owner.
Of course, the downside to investing in real estate is that there are ongoing expenses associated with renting property you own. These include mortgage payments, real estate taxes, maintenance, repairs and utilities. You’ll need to balance the potential investment income against these costs to make sure that real estate is a worthwhile investment for you.
#6: Mutual Funds
Money market mutual funds are funds that invest in liquid, near-term investments at a low level of risk. They may also be referred to as mutual funds. Some of the low-risk investments that may be included in a money market mutual fund include the following:
- Cash-equivalent securities
- High-credit-rating debt-based securities such as United States Securities
We should note that a money market mutual fund is not the same thing as a money market account, which is a form of interest-bearing account offered by credit unions and banks.
#7: Private Equity Funds
One of the riskiest ways to generate passive income is by investing in a business that you believe has long-term growth potential. You can mitigate the potential risks of putting your money into a single business by investing in a private equity fund, instead.
The downside of this strategy is that it’s not one that’s typically open to beginning investors. Many private equity funds have net worth and/or income requirements for investors, so if you don’t meet the requirements, you won’t be able to take advantage of investing in a private equity fund.
#8: Real Estate Investment Trusts
Real Estate Investment Trusts, or REITs for short, are companies that own and/or finance income-producing real estate across a variety of sectors that may include residential and commercial properties such as apartment buildings, office complexes, warehouses, factories, retail centers and even infrastructure.
The advantage of investing in REITs is that you’ll get many of the benefits of owning real estate without the expenses and responsibilities of doing so. Most REITs are traded on public stock exchanges, so investing in one can help you generate passive income. REITs are legally required to pay out at least 90% of their income in dividends.
#9: Peer to Peer Lending
Peer to peer lending can generate passive income when an investor loans money to another individual, often through a third-party site such as Lending Club or Prosper. The platform vets borrowers on behalf of investors and investors earn income in the form of interest.
We would classify peer to peer lending as a high-risk method of income investing because of the danger that someone you loan money to may default on their loan. If you decide to try peer to peer lending, you can mitigate your risk by spreading out your investment across multiple loans. You’ll need to make sure you meet the lending platform's income and net asset requirements before you invest.
#10: Dividend-Bearing Checking Accounts
A dividend checking account generates passive income by paying dividends to the account holder instead of interest. They are available only at credit unions because credit union members are also owners; the dividends represent members’ shares of the credit union’s profits. In most cases, these dividends are higher than the interest rates you would earn at a bank.
Dividend-bearing accounts are not associated with many risks, but there may be a minimum balance required before the credit union will pay dividends. For example, our Benefits Checking requires a minimum balance of $1,000 to earn dividends.
What Are the Tax Implications of Passive Income Strategies?
If you decide to pursue any of the income investing strategies we’ve listed here, you’ll need to understand the tax implications of doing so. If you invest in non-dividend-bearing stocks, you won’t pay any money on your gains until you sell your shares. That’s not the case with passive income you earn from your investments.
The Internal Revenue Service considers passive income to be taxable income. In most cases, however, it is not taxed at the same rate as ordinary income, which is what the IRS calls active income. Instead, it is taxed as capital gains. The tax rate you can expect to pay on your passive income depends on whether it is considered a short-term capital gain or a long-term capital gain.
You should know that, in most circumstances, long-term capital gains are taxed at a lower rate than short-term capital gains. Earnings are taxed as short-term capital gains if you have held the investment for less than a year and as long-term capital gains if you have held them for more than a year. The maximum tax percentage for short-term capital gains is 37% while the maximum for long-term capital gains is only 20%.
What we can learn from capital gains tax rates is that it is most advantageous to hold onto your income-earning investments for a minimum of a year to save money on taxes. We should mention here that earnings from interest and dividends are not taxed as regular income. Like capital gains, they are considered to be portfolio income.
Because the tax rules around investment income may be complex and confusing, particularly to beginning investors, you may want to work with an investment advisor to help you understand your income investing options and put together a portfolio that works for you.
Generate Passive Income with Your Investments
Passive income can be useful if you want to add to your income without taking on more work than you already have. The 10 assets we’ve listed here can help you build an investment portfolio that generates income.
Are you looking to earn dividends simply from your checking account? Addition Financial has what you need. Click here to read about our Benefits Checking account and join today!