5 Types of Passive Income YOU Need to Have
Amorosjbk63cdsHey guys, Toby Mathis here, and a lot of you guys know that I'm a tax attorney and that I've been doing this for a couple decades plus and that at Anderson we do tens of thousands of tax returns. We work primarily with investors, almost exclusively with investors, primarily folks that are in stock market and real estate but lots of different investments, and here's what I found after working with really wealthy folks over the years. They all have similar characteristics about the type of income that they make, and so I started noticing this probably 15 years ago and started tracking it. I used to use software to recreate people's assets so I could see what type of assets they were holding. There's insurance companies that use that, and I was like, "I've used it just 'cause I wanted to know what my clients were investing in," and then I started talking to more and more people, and then I started digging into the other tax information that's out there, including by the IRS, and this is what I found interesting.
There's really eight types of income, and you know the number one that everybody knows is W-2 income. The stuff that I make is my wages. Number two is, "Hey, there's profits that I make off of a business. Sometimes I'm a silent partner. Sometimes I'm active," and then you have things like rents, royalties, dividends, interests, and capital gains, both short term and long term. In all, there's eight types of income, and I started noticing that the wealth really focused on having multiple streams of income. In other words, they weren't relying on one type of income, and if that's you, and if you're looking at yourself going, "I want to be wealthy," and you realize all you have is W-2 income, then we need to diversify into other types of income, and so what I wanted to share with you today are the five types of income that you really need to have 'cause, again, when I look at the IRS stats, it's not even close. Most folks, most wealthy people, the ones that are making over a million dollars a year consistently, and you might say, "Well, those aren't wealthy. The wealthy are zero." It's not always possible, right?
There's some of that, but when you really look at wealthy folks, a lot of 'em do have high incomes, and they're just trying not to pay a killer amount of tax on money that sometimes they don't even receive. Sometimes you get phantom income, right? You want to mitigate that. If you are simply in real estate investments, you might get yourself pretty low, but the people making over a million bucks a year, sometimes they can't get out of the way of that income, and a lot of times, they don't care, and here's why they don't care, because they're taxed differently. So for example, dividends out of a business could be taxed as long-term capital gains, and long-term capital gains can be taxed at zero, 15 or 20%. It's capped at 20%. Now, some of you guys are wise enough to know, "Well, what about the net investment income tax?" Yeah, there's 3.8%, so 23.8%, that's your top bracket, versus ordinary income like wages where I'm taxed at 37%, plus I have employment taxes of 3.8% as a minimum, and when I first start, it's at 15.3%. So I'm just getting hammered with tax. You work at McDonald's, you're gettin' hit with employment taxes, your state tax, and your federal withholding, not to mention anything else that they could throw at ya. You have all these withholdings.
So if you make, whatever it is, 20 bucks an hour, now a lot at McDonald's, that's what they're gettin', right, and you work 40 hours, you're not gettin' 800 bucks, you're gettin' 600 and some dollars, right? They're giving you a net. The wealthy don't do that. What I've noticed is that the wealthy, about 96% of their income comes from these five sources, and so let me detail these five sources for you. Number one, we have rents. (light knocking) Most of the wealthiest clients that we have that I've met and that I run across, all of 'em have real estate that is rental real estate. Sometimes they have short-term rentals. Sometimes they have long-term rentals, and those are taxed very differently, by the way, from a standpoint of what I could do with things called depreciation. If I want to offset my W-2 income, I would go with short-term rentals because I can create ordinary loss. If I am just looking at saying, "Hey, I just want normal depreciation.
I just don't want to pay tax on the rents as I receive them," fantastic. Then you want to have long-term rentals. It works great either way, but they are a little different, but there's always rents, and again, it's up to 96% of the income. When you look at folks that are in the over a million dollars mark, 96% coming from these, and I'm going to lay them out even in greater detail. Rent, royalties.
(pen knocking) Some of you guys might be familiar with intellectual property, and sometimes you have royalty agreements. You can invest in these things and get royalties. Oil and gas creates royalties where I am getting revenue over a period of time. The only bad part with royalties is that they're taxed as ordinary income, but the good part about some of these investments is sometimes I get a big massive tax deduction in that first year. That's why a lot of rich people use it because they're like, "I want the tax deduction now." Why do I want the tax deduction now? Because a dollar today is worth more than a dollar in five years. In other words, "I need to get that dollar today." If I have a chance of getting a tax deduction and saving that dollar today and paying a dollar in five years, I'm going to do it, and that's 'cause I get used of this dollar for the next five years. A lot of times, I'm able to double that dollar in five to seven years, depending on what you're doing.
In the stock market, on average, it's over 10% a year, the S&P 500. So that's seven-year doubling, right? So if I can get that dollar, chances are I can make back what I ended up having to pay in tax. So I want that dollar, and that's what royalties oftentimes get us, rent, royalties, dividends. Interest (pen knocking) is our next category. Interest, again, is ordinary income, but if you have notes, if you're using things like Prosper or Groundfloor, if you're doing lending, you could even do lending out of your IRA or 401K, (chuckling) believe it or not, but you get interest, and you start making money from what people are paying you for the use of your money, it's called interest, and again, wealthy folks have all three of these categories. Quite often, they have all five types of income. Sometimes they have six, but in most cases, they have at least three. In fact, the majority of returns that I looked at that were over a million dollars had at least three, had at least three types of income. So if all you did is you had your W-2 income and you added one or two of these, you're great, but we have rent, royalties, interest, and then this is the big one.
(pen knocking) dividends. I don't know what happened over the last couple generations, but our grandparents would invest for dividends. They would invest in businesses, expecting to get paid. They wouldn't invest in something and hope that it goes up. They didn't care if it went up. If I gave Uncle Ned a loan for his business, right, and he's paying me interest, I don't care about the business. If I gave Uncle Ned a contribution into his business and I said, "Hey, I want to be a part owner," I want to get paid. I'm not hoping that someday we sell the business and I get money. What I'm saying is, "Hey, gimme part of that profit every year, Ned." "Uncle Ned, we're makin' money on pizzas. Gimme some of that." Maybe I'm a 50/50 owner. "I want 50% of the profit. Gimme that." Well, that's dividends. Dividends from publicly traded companies, US companies, are taxed as long-term capital gains, which means they're at zero, 15 or 20%, (pen knocking) depending on your tax bracket. They get preferential treatment. That's why rich people love dividends 'cause, number one, that's a huge chunk of the revenue that comes in that's part of the S&P. It's about 40% of that growth of 10% a year. It's over 10% a year, almost 11%, the S&P, historically, since its inception has returned, and about 40% of that is dividends.
If you're not getting dividends on your investments, you're literally just leaving money on the table, and there's folks that invest in companies. They're called growth companies. They don't pay anything. They don't make profits that they pay out to shareholders. It's crazy. Like, "Why would you do that?" Remember what I said about a dollar today is worth more than a dollar tomorrow? Why would you just hope that you get your dollar back, and maybe it goes up in value? I want to get paid as we go along. You know who's really good at this? Warren Buffett. (popping) Warren Buffett bought Coca-Cola back in the eighties. He's getting hundreds of millions of dollars off of Coca-Cola and Apple in dividends every year. It's a ridiculous amount of money. Berkshire Hathaway makes a crud, just a huge amount of money just on the interest (chuckling) of the money that it has, right?
They're really good about getting multiple streams of income off their portfolio, yet if you talk to people, they'd be like, "Oh, he's really good at picking stocks." Yeah, Munger, it's not just picking stocks, is Buffet and Munger, what they're really good at is making money in multiple streams of income. So we have our rents, our royalties, our interests, our dividends. This last one's going to throw you for a curve. This is weird, but trust me on it.
Short-term capital gains, (pen knocking) short-term capital gains, and you're going to say, "Why would you have short-term capital gains? It's tax as ordinary." The reason people love this is this is when you become a stock market landlord. This is when you start renting your stocks out to other people, and folks go, "Is that shorting?" No, I'm talking about selling covered calls on a stock portfolio. I call it being a stock market landlord because I own a whole bunch of stock, and I sell the right to somebody else. I rent it to 'em and say, "Hey, if you think this is going to go up, you can buy it from me at X." So if I have a stock that's worth a hundred bucks and, hey, it could go up to 110, and somebody's willing to gimme a dollar, I'll pay you a dollar a share to buy it for $110 for the next three months. Okay, okay, it's worth a hundred bucks right now. So now I get a dollar, and you're going to gimme a dollar. I'm going to make 1% for the next three months. I'll take that, absolutely, 'cause what's the worst thing that could happen? Okay, I have to sell 'em my stock at $110, and I got to keep the dollar anyway. So I actually made $111, and it's worth a hundred bucks right now. So I'll take that action all day long, and really smart people, that's what they do.
In fact, Kevin Simpson, one of my favorite guys, I get him on my show and talk all the time, he runs a company, an ETF, called DIVO, and that's all they do is covered call strategies. They're really, really good at this. I know other folks that are really, really good at generating covered call income because it's not that difficult. Anybody could learn it. So here's the five types of income, five, right?
(pen knocking) You could add those easy. I could very simply, even if I'm a W-2 wage earner and I'm like, "I've never had another source of income," I could buy stocks and getting dividends, get up to, you have to have 100 shares, and I could sell an option. I could get two types of income pretty easily. Then I maybe put my sights on, "Hey, what if I want to get some rental properties?" That's where I would start. Maybe I go to Prosper and throw a few thousand dollars in there and start generating some interest, and all of a sudden, I have four or five types of income, but these are the five that I would concentrate on, and it's a lot of fun (chuckling) once you start getting into multiple streams of income. You just got to take my word on that. Hey, if you like this type of content, please share it with other people, and if you can like and subscribe and then let me know below your favorite types of income. Of these five, what are your favorite? Put it in the comments below, just for fun.
Thanks, guys.
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