What Is Passive Income?
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I was interviewed recently by a journalist, when Cash-Smart Kids was voted “Web Site Most Likely To Change The World”. She said she was a little embarrassed to admit that she wasn’t quite clear on the meaning of the term “passive income”, and we agreed she probably wasn’t alone.
How can parents explain these ideas to their kids if nobody has ever explained them to the parents in the first place?
This post is the first in a series providing definitions of key money concepts, and suggestions for simply ways to explain the concepts to your kids.
We distinguish two types of income - active income, and passive income. The Australian Taxation Office refers to them as “personal exertion income” and “unearned income”, which I think is a bit rough. Most people I know who have passive income worked very hard to build it up, thank you very much! They have certainly “earned” it.
The difference is that with active income, you are trading your time for money, while passive income will keep coming, whether you get out of bed in the morning or not.
The most obvious form of active income is having a job. You put in a certain number of hours, and you get a certain amount of dollars in exchange.
There are other forms of active income - if you make things and sell them, that is still active income, because you have to put time into the making and the selling.
If you organise other people to do the making and the selling, and you get a percentage of the profits because the people are using your design, then you don’t have to put time into it any more. It has become passive income.
This is a form of passive income called royalty income, or licensing income.
Other forms of passive income are interest, rent, and dividends. These forms of income require you to have an asset (cash generates interest, real estate generates rent, and shares generate dividends).
Your kids can grasp this concept fairly readily. We played Robert Kiyosaki’s Cashflow 101 with our kids - it is a game specifically designed to get the idea of passive income across to the players. By the time they were ten, they all understood it.
You can give your kids a powerful visual demonstration of the power of compound interest by playing a game with them. Ask them to save their allowance money, and not spend it. Each day, check their balance, and give them a payment of interest. Each day, the payment will be higher (in the best of all possible worlds, one of your kids will break ranks and spend some of their allowance, while the others hold firm, to give a direct contrast). Make the interest payment big, 50%, or even doubling their money, so they can see the power of compounding in just a few days.
After a week, show them that they can spend the interest each day, and leave the original investment in place to earn them more interest the next day.
Most kids grasp it pretty well - just be prepared for the inevitable question, if you are still heading off to a job every day.
“Why don’t you do that, then, Mummy? Then you could stay home all day and play with us!”
