Passive income is tough
Why is it so difficult to build your passive income streams for early retirement? Basically, the world is against you. Here are a few reasons why.
Time is not on your side – Early retirement means less time in the workforce and more time in retirement. You would have fewer than 20 years to save and invest before you retire by 40. The earlier you retire, the more years you spend in retirement. Your passive income would need to keep pace with inflation and changing economic conditions for 40-50 years. That’s tough.
Lifestyle inflation – It is inevitable to spend more money every year. The cost of goods increases every year and there are always new services and products. Most families are so caught up with lifestyle inflation that they can’t even save 10% percentage of their income. Saving 10% per year will be barely enough for retiring at 65 and most people can’t even consider retirement. Lifestyle inflation is why early retirement is out of reach for most people.
Low rate of return – Another problem with passive income is the low ROI. I’m going to be conservative and say we can generate about 3% of passive income from our investments. Our annual expense is about $55,000 so we’d need around 2 million dollars to cover our cost of living. That’s not easy to do within 20 years.
Accessibility – We have a little over $2 million in our investments, but they are not very accessible. The bulk of our investments are in our tax-advantaged accounts and we need to do some work to be able to access them without paying the 10% early withdrawal penalty. Our rentals are returning much less than 3% and they are not very liquid. They should improve over time, but they are not very efficient right now. This means we need to accumulate even more than 2 million dollars and keep working to improve our ROI.
See, passive income isn’t easy. That’s why I think working part-time is a more realistic way to go for early retirees.
Early retirement doesn’t have to mean a full retirement
Passive income is simply income from sources other than work. Active income is income that you have to actively spend time on i.e. a steady job at a workplace that hired you. Most families rely on active income to pay the bills, but we all have to retire eventually. At that point, you will have to rely on passive income to fund your lifestyle. However, it doesn’t have to be an abrupt switch from full-time work to full-time retirement. My brand of early retirement is the middle ground and it is much more accessible to anyone who puts their mind to it.
I quit working full-time and transitioned to part-time self employment. I’m doing something I enjoy and I’m making a little money to help pay the bills. Passive income is very helpful because it offsets the amount active income I’d have to make. In 2015, our passive income covered about 55% of our cost of living. I call this the FI ratio. I’m working to increase our FI ratio and eventually passive income will cover 100% of our living expenses. I will then have the option to retire full-time. At this point, I like working part-time. It makes me feel productive and connected to the world. Part-time self employment is the ideal situation for me and my family. Things always change, though. It’s best to ramp up our FI ratio to 100% as soon as possible just in case.
Passive Income
I originally wrote this post at the end of 2012 and things have changed quite a bit since then. At that time, my goal was for our passive income to cover about 50% of our expenses. We thought Mrs. RB40 would continue to work for at least 15 years so my goal was a bit low. She liked her job and enjoyed being a productive part of society and I didn’t think she was ready to join me in early retirement. Fast forward to 2016 and Mrs. RB40 now wants to retire soon. She still likes work, but she wants more time to work on her other projects. Part-time work would be ideal, but she can’t do that at her current job. Consequently, our new goal is to cover 100% of our expenses with passive income plus my online income. Let’s see where we are in 2016.
Dividend Stocks
Dividend stocks are a great source of passive income because they have the growth potential of stocks and a favorable tax rate. In 2015, we paid no taxes on our dividend income and it felt great. Don’t worry, the IRS isn’t going to throw us in jail. We were in the 15% tax bracket and it’s perfectly legal to pay no tax on our dividend income.
For 2016, we should receive about $11,500 in dividend income. That’s a nice increase from $7,500 in 2012. Our dividend should continue to grow every year because I invest in companies that have good track records of increasing their dividends. This niche is called dividend growth investing. We also add to our dividend portfolio whenever we have a little extra cash.
Rental Properties
Currently, we have a duplex and half share of a rental condo. For 2016, we should make about $3,000 in rental income. This is just the income after mortgage, property tax, maintenance, repair, utilities, and other expenses. I’m not counting depreciation, appreciation, or principal reduction. 2017 should be better because I’m planning to raise the rents to reflect the market rate at the end of the year. The rental market in Portland has been on fire over the last few years.
Our rental income has been lower than I expected because there have always been some big repairs to be done. The silver lining is the property price appreciation. Our properties have appreciated quite a bit over these past 4 years. Hopefully, the rentals will generate more cash at some point.
Peer To Peer Lending
I have about $10,000 at Prosper.com and about $1,500 at KickFurther. The ROI is about 8% and we should generate about $1,000 in 2016. Recently, I’ve been thinking about moving the money from Prosper to real estate crowd-funding. Maybe I can do it next year when I have more time.
Retirement Accounts
The bulk of our investments are in our tax advantaged retirement accounts. Once Mrs. RB40 retires, then we can start building a Roth IRA ladder to access those accounts. For 2016, our tax-advantaged accounts should generate about $23,000 in passive income. These are all in passive index funds so the ROI is just around 2%. We could focus on more income by investing in dividend stocks when we do the rollover process.
FI ratio
Here is a simple way to track our progress toward financial independence.
FI ratio = passive income / expense
We should make about $38,000 in passive income in 2016. On the denominator side, our expense should be around $55,000 this year. So our FI ratio for 2016 should be around 70%. Actually, I would be very happy with 65%. We’ll see how the rest of the year goes.
Active Income
65% isn’t bad, but it isn’t 100%. We’re still short about $17,000. Luckily, my online income* makes up for the shortfall. That’s why I say a little active income goes a long way in early retirement. I only need to make $17,000 and our cost of living would be covered in 2016. Anyone can make $17,000 per year, right? In theory, Mrs. RB40 could retire this year if she really wanted to. However, she needs a little more sense of security so she will work a little longer. I think our FI ratio should be very close to 100% in 2020. She should be secure enough to retire early then. Another option is to relocate to an area with lower cost of living. We’ll keep that option in our back pocket for now.
*I will break down the online income in our monthly newsletter so if you’re curious, sign up with our email list.
Passive income is a great way to pay for early retirement. You don’t need to cover 100% of your bills if you’re willing to work a little bit. A little part-time work is actually good in retirement. It helps you pass the time and avoids driving your spouse nuts. I’m planning to keep working part-time for at least 10 more years. This will enable our investment to grow at a higher rate because we’ll be able to reinvest more. We may not be able to cover 100% or our income by 2020, but I’m confident that we will get there someday. Meanwhile, I will continue to work part-time on something I enjoy.
What about you?
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Image by Giorgio Montersino
A Little Active Income Goes a Long Way in Early Retirement is a post from: Copyright © 2010-2016 Retire By 40 All Rights Reserved
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