Passive Income: How to Make Your Money Work For You

Ever hear the saying "let your money work for you?" That's the mindset behind passive income, or earnings generated with minimal effort. While active income usually comes from a job or a business that requires, you guessed it, active participation, types of passive income include things like earnings from investments or rent from investment properties. Building out your revenue streams can be rewarding, grant you additional financial stability (or independence!) and help shape your big-picture financial plan. Let's look at what that means.

Types of passive-income investments

Investments that can generate passive income generally fall into these categories:

Real estate. Rental income is the primary way of making passive income from real estate. That can include renting apartments or short-term accommodations. About two-thirds of Canadians are homeowners. In 2020, almost eight per cent of Canadian households declared rental income, up from seven per cent in 2008.

Business or entrepreneurship. If you have a hands-off role at a company (say, one structured as a limited partnership), there are ways to make money without directly managing the business. Selling copies of on-demand courses, art or other content online is an example of a business model that can be mostly automated after the initial creative work is done.

Fixed-income products. As the name implies, these investment vehicles are a source of fixed, or regular, income. Bonds typically net you semi-annual interest payments. Fixed-income mutual funds or ETFs (exchange-traded funds) are professionally managed and provide opportunities to diversify your account. GICs, or guaranteed investment certificates, have become more popular as higher interest rates have increased their returns.

Other income-generating securities. This category includes so-called "income stocks," or stocks that pay dividends¹. Companies that pay dividends tend to be more established and well-managed — and have less volatile share prices — than those that do not. There can be tax advantages to holding dividend-paying securities in registered accounts (more on that below!); for non-registered account holders, the Dividend Tax Credit may offer another way to catch a tax break.

As you might have noticed, few of the income streams listed above are truly "passive." For example, real estate requires a degree of property and tenant management, and stocks may require planning and monitoring a portfolio. They also require up-front effort – consider the work it takes to start up a business venture versus simply signing up for an investment account online. These are important considerations when planning out a passive portfolio.

The benefits of passive income

Passive income can be appealing for many reasons. A little extra cash flow is always nice – especially if it is regular and predictable, which makes projecting future income a snap. Additional income can supplement your paycheque or retirement income, help you diversify, serve as a buffer against economic downturn or bolster your emergency fund. Plus, the often minimal effort required to generate passive income frees up time to focus on interests and other important work. Put simply, more cash flow gives you more options. 

Risks of passive income

It's important to note that passive income doesn't mean easy money. As with all investments, returns can fluctuate with the markets. Companies are not obligated to pay dividends, interest rates can take bonds and real estate prices for a ride, and inflation can put a dent in online sales. And, depending on your source of income, different tax rules may apply.

Some of these risks can be limited through increasing your sources of passive income. As a rule of thumb, the more sources of passive income you have, the more insulated your holdings are from volatility.

How investors use passive income

With that in mind, passive income can be a powerful tool in an investor's portfolio. Some popular investing strategies include:

Reinvestment. Reinvesting gains can help increase your earning potential over time – think expanding a business to make more sales. In an investment portfolio, the reinvestment of dividends from certain stocks, ETFs or mutual funds can buy you more units or shares that in turn can increase the total return on your investment. (And as you may know, compounding can be an amazing thing.)

Good to know: You can set a dividend reinvestment plan², or DRIP, to automatically reinvest cash dividends for DRIP-eligible securities. A stock's detailed quote page offers information about a stock's eligibility, its dividend yield and more.

Retirement. Passive income can supplement an investor's retirement income with regular inflows to live off of and help sidestep the need to sell off assets to generate income. Some investors aim to grow their passive-income streams to replace employment income entirely, as in the Financial Independence, Retire Early (FIRE) movement.

Diversification. As part of a balanced portfolio, passive-income generating assets can provide stable income alongside more volatile investments or assets that must be sold before you can make money. Mutual funds and ETFs are one way to add diversification to your investments.

Tax-advantaged accounts. Canadians can hold certain income-generating securities in registered plans, including TFSAs (Tax-Free Savings Accounts), RRSPs (Registered Retirement Savings Plans) and FHSAs (First Home Savings Accounts). These accounts allow investors to defer or minimize the taxes they would otherwise owe on earnings from their investments.

Getting started? Get creative

There are many ways to earn passive income. Wondering how to pick one and get started? A great first step involves evaluating your income goals, risk capacity and how much work you are willing to take on.

For many, investing can be an accessible path to earning regular income. Real estate may be attractive to investors who prefer working with something they can see and feel. Or perhaps you like the idea of a side hustle? Look to your unique skills and interests for inspiration. With a bit of research, you can find a method that works best for you.

At RBC Direct Investing, stock screeners may be a good place to start as you can produce a list of stock ideas based on setting your own dividend yield criteria. Interested in fixed income? Get an idea of GIC rates and other bonds on the fixed-income order entry screen.