What is passive income and why is it so important?

There are lots of different ways to make money as an independent musician, but in this post I want to talk specifically about a certain type of income called “passive income.” In fact, regardless of your profession, it’s important to recognize that there are two primary ways of generating income: actively and passively. “Active income” means that you have to continue doing a meaningful amount of work in order to continue generating income. “Passive income” means that after doing some upfront work, you can continue generating income with very little effort or even with no work at all.

Active income versus passive income

Some methods to generate income are clearly active. For example, most 9-to-5 jobs are active income sources: as soon as you quit or you are fired from your job, you stop earning income from your employer. Likewise, some methods to generate income are clearly passive. For example, once you upload a video to YouTube and set up ad monetization for it, there is nothing more you have to do: even after a decade, you can continue to collect the royalties from YouTube for plays of your video. As to be expected, some methods for generating income have both active and passive elements, blurring the lines between the two approaches.

In my opinion, the primary distinction between active income and passive income is how much of your time is required to keep it going. Sure, passive income may require a large amount of upfront time… but after it is set up, very little time is required to maintain it.

If you only pursue active income, you’re basically putting an artificial cap on the amount you can earn. In addition, you are operating at a much higher level of financial risk.

Although active income can be fantastic for earning a substantial amount of income quickly, I would highly recommend building up your passive income as a long-term strategy. Why? Well, everyone has the same 24 hours in a day. If you only pursue active income, you’re basically tying your income to your time and putting an artificial cap on the amount you can earn. In addition, you are operating at a much higher level of financial risk. What happens if you want to stop working… or worse yet, you have to stop working because of illness or something out of your control? If your income only comes from active sources, you risk not earning any new money thereafter. With active income, you cannot “spread out the risk” because you can’t divide up your time like that.

If a handful of your passive income sources suddenly fail, you still continue earning income from all of your other passive income sources!

However, with passive income, you don’t have an artificial cap on the amount you can earn because your annual earnings aren’t tied to the time you put in each year; rather, your earnings are tied to the upfront time and effort you originally put in to start up the passive income source. And with passive income you can indeed spread out the risk across a portfolio of passive income sources. You can create lots of different sources of passive income, since your time is not tied up with an active job that always requires your attention. If a handful of your passive income sources suddenly fail, you still continue earning income from all of your other passive income sources!

What does this mean for indie artists?

Of course, this applies to any type of profession, but as an independent artist, imagine your sole form of income is active income that comes from playing gigs. What happens if/when you no longer play new gigs? Does that mean your music career is over because you can’t support yourself anymore? What a bummer! Now consider a situation where your income comes from passive sources such as streams on music services such as Spotify and Apple Music, as well as downloads on iTunes, and a monthly fee your fans give you to be in your VIP membership club. If you decide to take a few months off to explore a new song or album idea, what happens to your income? Your income is basically unaffected by your day to day actions.

Example A: Active income method

Let’s take a look at a more complete, general, over-simplified example. 😉 Consider a normal “day job,” and to keep things simple, let’s bundle the income, pay raises, and bonuses you would get into a single maximum number that you will ever earn from that day job on an annual basis. Obviously, each person’s numbers will be different, but let’s just say that number is $100,000 per year. So, in 5 years you will have earned $500,000 from your active work. Now, let’s say you decide to stop working after 5 years, in which case you naturally stop earning the $100,000 per year for your active work. Here’s what your 30-year forecast looks like.

Example A: Total cumulative earnings from 1 source of active income, requiring 5 years of work:

Year 1 = $100,000 ($100,000 per year)

Year 2 = $200,000 ($100,000 per year)

Year 3 = $300,000 ($100,000 per year)

Year 4 = $400,000 ($100,000 per year)

Year 5 = $500,000 ($100,000 per year)

Year 6 = $500,000 ($0 per year; stopped working)

Year 7 = $500,000 ($0 per year)

Year 8 = $500,000 ($0 per year)

Year 9 = $500,000 ($0 per year)

Year 10 = $500,000 ($0 per year)

Year 20 = $500,000 ($0 per year)

Year 30 = $500,000 ($0 per year “forever”)

Example B: Passive income method

Now let’s take a look at a possible passive-income approach. Instead of working 8 hours per day at a job, you spend 8 hours per day for three months straight setting up a form of passive income that generates a measly $5,000 per year. Whoopdeedoo! 😉 Stay with me, though. After three months, you’ll continue to generate that $5,000 per year without having to spend any substantial amount of time going forward. For the following three months, you decide to spend your time to set up yet another form of passive income that generates another $5,000 per year. You do the same for the next two quarters so that by the end of the year, you have four streams of passive income generating a total of $20,000 per year, without requiring you to spend more than a few hours here and there to maintain it.

If you stopped working after the first year, here is your extremely simplified 30-year forecast. So that we don’t have to hurt our heads doing complicated math, let’s just assume you don’t see any of the passive income money until the next year… and it all comes together in a lump sum. 🙂 This, of course, will grossly underestimate the earnings, but I’m confident you’ll see how powerful passive income is even if we handicap it like that.

Example B: Total cumulative earnings from 4 sources of passive income, requiring 1 year of work:

Year 1 = $0

Year 2 = $20,000 ($20,000 per year; stopped working)

Year 3 = $40,000 ($20,000 per year)

Year 4 = $60,000 ($20,000 per year)

Year 5 = $80,000 ($20,000 per year)

Year 6 = $100,000 ($20,000 per year)

Year 7 = $120,000 ($20,000 per year)

Year 8 = $140,000 ($20,000 per year)

Year 9 = $160,000 ($20,000 per year)

Year 10 = $180,000 ($20,000 per year)

Year 20 = $380,000 ($20,000 per year)

Year 30 = $580,000 ($20,000 per year “forever”)

Interesting… after 30 years, our total earnings from 1 year of passive income surpassed the active income from 5 years of work. But just because you have some passive income after one year doesn’t mean that you can, should, or want to stop working. So, rather than stopping after the first year, let’s say you create four new streams of passive income each year for the remaining four years, for a total of five years of work. That means you’re going to add an additional $20,000 of income per year! Here’s what the forecast looks like now:

Example B: Total cumulative earnings from passive income (adding 4 new sources per year), requiring 5 years of work:

Year 1 = $0

Year 2 = $20,000 (4 sources = $20,000 per year)

Year 3 = $60,000 (8 sources = $40,000 per year)

Year 4 = $120,000 (12 sources = $60,000 per year)

Year 5 = $200,000 (16 sources = $80,000 per year)

Year 6 = $300,000 (20 sources = $100,000 per year; stopped working)

Year 7 = $400,000 (20 sources = $100,000 per year)

Year 8 = $500,000 (20 sources = $100,000 per year)

Year 9 = $600,000 (20 sources = $100,000 per year)

Year 10 = $700,000 (20 sources = $100,000 per year)

Year 20 = $1,700,000 (20 sources = $100,000 per year)

Year 30 = $2,700,000 (20 sources = $100,000 per year “forever”)

Now we’re talking! To be fair, in reality each passive income source probably has a finite lifespan. Some passive income sources might dry up after a few years, while others might continue going strong decade after decade. Also, some forms of passive income can require a large amount of capital, such as real estate investments and stock market investments. Nevertheless, I think the concept and power of passive income is pretty clear at this point. The exact numbers used in the examples don’t really matter… it’s the concept and how it can apply to your situation that is important.

It is interesting to note that passive income is a form of delayed gratification.

It is interesting to note that passive income is a form of delayed gratification. You are choosing to do a lot of upfront work and get very little upfront income in order to eventually get a small amount of income, year after year. You’ll notice in the example that it took 8 years for the passive income approach to generate the same amount that the active income approach generated in 5 years. But after that, the passive income approach totally blew away the active income approach.

I didn’t get anything you just said… can you summarize your entire article, please?

Sure thing! So what are the takeaways from all of this?

  • The passive income approach means doing a lot of upfront work to set up a continued source of income that doesn’t require a lot of ongoing work; it’s sort of like paying lots of money to buy an annuity, which then pays you back a small amount each year for many years to come.
  • Passive income can possibly help you earn more than you could with active income
  • Having lots of sources of passive income can help reduce financial risk
  • Setting up new sources of passive income can sometimes require a lot of time and effort in the beginning
  • It may take a long time before you start seeing income from a new source of passive income; in this way, active income is much more appropriate if you need money quickly
  • Being passive-income aggressive is much better than being passive aggressive! Well… that technically wasn’t in the article, but I thought it was worth noting. 🙂

NOTE: I hope to post an article soon that lists a bunch of ways that independent artists can generate active and passive income from their music.

Oh, and with all of this talk about making money, don’t forget to follow these tips to save money and also give back to the world.

If you found this article helpful, please share it with others. And if you have some cool insights about this topic that you think might help others, please share it in the comments section below.

Enjoy!

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