Tracking Your Passive Income: Another Key Metric in Assessing Your Financial Progress
In my late teens and early 20s, I was intrigued by personal finance and investing. My Dad had a demanding job as a materials & logistics manager for Ford Motor Company. His long days required him to leave the house before we woke up and he generally returned home twelve hours later in time for dinner. His home office was overflowing with books. Most of them were personal finance books. As the oldest of six kids, who was about to graduate from college and attend law school, I was curious and started reading his books.
Specifically, Dad owned a few of Robert Kiyosaki’s books from his Rich Dad, Poor Dad series. If you have read any of Mr. Kiyosaki’s books, you know he wrote about his “Rich Dad” who made money while he slept. My dad was trying to learn how to make more money while he slept so he could presumably retire and/or reduce his time at work. Wait, I want to make money while I sleep too!
The concept of making money while I slept stuck with me and has motivated me since my early 20s. What if I could save my money, invest it, earn interest and dividends from my investments, and replace my earned income? At that time, I concluded this was the best way to gain financial independence. And I still believe it to this day.
In recent discussions with clients who are aggressively saving, I have shared this story with them. I make the case that another way you can chart your financial progress is by looking at the percentage change in your passive income from one year to the next.
What is passive income?
Passive income is the income you generate from sources such as dividends (profits) from investments, interest from owning bonds, certificates of deposit, money market accounts, or income from owning rental properties. Basically, it is the income you receive annually from sources that do not require you to actively perform any work.
What are the benefits of tracking my passive income growth?
First, focusing on the year-to-year growth of your passive income is going to turbocharge your growth mindset. When you start tracking this metric, it will force you to think about saving and investing. What new opportunities are there for growth? Am I re-investing my dividends as opposed to spending them? What other sources of passive income should I consider adding to my portfolio? Many young investors may not fully appreciate their progress if they are only tracking the growth of the market value of their assets from year to year. Shifting the focus to include dividend and income growth will motivate and induce positive financial habits that will keep you and your family on track to enjoy a comfortable retirement.
For my clients who prioritize financial independence, their annual passive income growth is a critical metric. Tracking this figure will help them understand their cash flow and help them determine whether they will be able to achieve a sustainable level of income that will support their lifestyle without actively working to earn their income. And, if passive income is not growing as much as they expect, it will signal that adjustments may be necessary. Should we increase contributions, save more, and/or adjust the asset allocation?
Passive income and Inflation
Investors planning for a comfortable retirement need to consider the effect inflation will have on their annual expenses. Further, they must consider the inflation risk they have on their capital by being overweight in cash or cash instruments. In June 2020, I wrote this blog on dividend payouts during recessions
It has aged well! In this blog post, I write that over the last century, dividends have grown at approximately 5% while inflation has grown at approximately 3%. It is also noteworthy that in 2022, while the S&P 500 had a temporary decline of approximately -18.5%, the S&P paid a record dividend that year. The dividend the S&P paid in 2022 was 11% higher than 2021 when that index was up almost 30%! Another important reason to track the change in your annual passive income is you will focus on one of the best ways to fight inflation during your retirement years – owning the great companies of the world that return profits to their owners in excess of inflation.
Tax Implications of Passive Income
Passive income has unique tax implications. Tracking changes in your annual passive income will make a difference in tax planning. Different types of passive income may be taxed at different rates or be eligible for specific deductions. Understanding the growth or decline of each income source allows you to adjust your tax planning approach, ensuring you maximize deductions and take advantage of tax-advantaged accounts. Proactive tax planning will help you retain more of your income, enhancing your net earnings and making your passive income streams even more valuable. These are the discussions we love to have with you and your CPA.
Conclusion
As I write this blog a couple of weeks before Thanksgiving 2024, it has been – up to this point – a great year for our clients and their wealth management plans. As we review 2024 and look toward 2025, let's celebrate our progress and consider how much more passive income we earned in 2024 than we did the year before. Tracking annual increases in your passive income is a crucial step toward long-term financial independence and security.