When you’re trying to pay off debt, save for retirement, or reach any other financial goal, having an additional income stream can go a long way. Not only that, but extra income can help pad your budget during times of high inflation or help keep you on stable ground if you lose your primary source of income.

But bringing in additional income is often easier said than done, especially if you already feel like there aren’t enough hours in the day.

That’s where passive income comes in. While it may require some time or money to get started, passive income then allows you to bring in an additional income stream without trading your time for money. Keep reading to learn more about what passive income works, passive income ideas, and how to minimize taxes on your passive income.              

What is passive income?            

There are two ways we can define passive income. First, passive income describes income you earn with little to no ongoing effort. Of course, that definition makes it sound easier than it really is. After all, if there were a way to make money with no effort, wouldn’t everyone do it?            

Generally speaking, you’ll need one of two things to start earning passive income: time or money. Sure, passive income can eventually provide you with extra money with little to no added work.                   

But before you get to that point, you’ll have to make a time or money investment to get it started. The good news is once you make that investment, passive income can start rolling in without trading your time for money.                          

The other definition of passive income comes from the IRS and is defined as either rental activities or trade or business activities in which you don’t materially participate throughout the year. This definition is important because income from passive activities has a special tax treatment.   

For the purposes of this article, we’ll be using the first definition of passive income, which is income you can earn with little to no ongoing effort (note that some of these ideas may not be considered passive income by the IRS).                                  

Ways to maximize your investments

One of the best ways to create passive income is to maximize your investments. Of course, this passive income strategy requires an upfront financial investment. It’s generally best suited for those who have excess cash today and want to use it to create passive income for the future.

Here are some ways you can use your investments to create passive income:

1. Dividend stocks and funds   

Dividends are payments that companies make to their investors as a way of passing along their profits. Dividends are usually paid on a quarterly basis (though they can also be paid monthly or annually). They’re usually issued on a per-share basis, meaning each shareholder will receive a certain dollar amount for each share they own.

Companies don’t have to issue dividends, but many do as a way of rewarding and enticing investors. You can create passive income from dividends by investing directly in dividend stocks or by investing in dividend mutual funds and exchange-traded funds (ETFs).

2. Bonds and bond funds

A bond is a debt security that a company or government entity issues as a way to raise capital. An investor lends the issuer money by purchasing the bond. In return, the bond issuer makes interest payments to the investors throughout the life of the bond. When the bond reaches maturity, the issuer will return the investor’s principal investment.             

Bonds pay interest on a set schedule, usually twice per year. The amount you can earn is based on the interest rate of the bond. Like dividend stocks, you can make passive income from bonds by directly purchasing bonds or by investing in bond mutual funds and ETFs.

3. Real estate

Real estate has the potential to provide passive income in a couple of different ways:

Real estate investment trusts (REITs): REITs are publicly-traded trusts or companies that own and manage real estate. By investing in REITs, you’re buying a small piece of ownership of the trust or company that owns the property and, in return, will get a small piece of the profits.           

Real estate crowdfunding: Similar to investing in REITs, real estate crowdfunding allows you to pool your money with other people to invest in real estate. There’s generally a company that directly owns and manages the real estate and passes along profits to the investors.

4. CDs, HYSAs, high-yield cash account

Certificates of deposit (CDs), high-yield cash accounts, and high-yield savings accounts (HYSAs) are banking products that allow you to earn interest on your money. They work similarly, where you deposit your money in the account and earn a set amount of interest.

HYSAs work like any other savings account, where you can deposit and withdraw money at any time. CDs usually require that you lock up your money during the CD’s term and can withdraw it when the CD reaches maturity.                                                                 

High-yield savings and cash accounts can both earn competitive interest rates. But there are a few significant differences:                                                           

• A savings account may limit your transactions to a certain number per month, whereas a cash account may allow for more.
• Some cash accounts also allow for check writing, while savings accounts typically do not.                       

While CDs and HYSAs generally have lower returns over time than other investment opportunities, they also have a considerably lower risk because they are FDIC insured (up to applicable limits). In other words, there’s no chance of losing your money in an FDIC-insured account.

Other passive income ideas for beginners

Investing is one of the best ways to earn passive income because it can require low amounts of time. However, it does require an upfront financial investment, which not everyone can make. Fortunately, there are other forms of passive income that require a bit of upfront effort but then allow you to earn passive income from your work.

Here are a few ideas:

• Create and sell an online course or e-book in an area of interest
• Become an affiliate for products and make money with affiliate marketing
• Sell your art or photography online
• Rent out your car or a room in your home

When trying to decide the best way to earn passive income, start by thinking of what you enjoy doing.

If you already create art or take photos as a hobby, it would be easy to start selling your work online. Meanwhile, if you love writing, creating a blog and making money with affiliate marketing or advertising may be a better option.

Remember that each of these types of passive income will require upfront work on your part. The amount of work required depends on the passive income stream you choose.

There’s not necessarily one source of passive income that’s best for everyone. However, it’s worth considering what will earn you the most money for the least amount of work (and will continue to make you money on an ongoing basis).

Minimize taxes on income

Just like the income at your full-time job, the money you make from income sources will be subject to taxes. And if you don’t plan ahead, you could end up with a large and unexpected tax bill at the end of the year (or in trouble with the IRS if you fail to report all your income and pay all your taxes).  

One of the simplest ways to minimize your tax burden is by writing off your business expenses. Generally speaking, you can write off any expenses that are both ordinary and necessary for your line of business. For example, if you set up a website, the money you pay for your domain name and website design would be ordinary and necessary for your business.

Deductible business expenses directly reduce your taxable income. For example, if you earn $1,000 and have $250 of deductible expenses, you have a taxable income of $750.

Another way to minimize the taxes on your income is to invest the money in a tax-advantaged investment account. When you earn passive income from a side hustle, you’re able to set up a retirement account for self-employed individuals, including a SEP IRA or solo 401(k). Even if you choose not to set up one of these accounts, you can invest the money in a traditional IRA.

Each dollar you contribute to one of these tax-advantaged accounts has the potential to reduce your taxable income and, therefore, reduces the amount of taxes you’ll pay for the year.

Note that you can generally only take expense deductions or make retirement account contributions on earned income as defined by the IRS.                    

Next steps for you

Passive income can go a long way in helping you reach your financial goals. It’s also important to have the right financial tools to help inform your decisions. Empower offers tools for managing your finances, including budgeting and cash flow tools, a savings planner, an investment check-up tool, and long-term retirement planning features.