A couple of weeks ago, my friend mentioned that he wants to find ways to generate passive income, you know, the type of income that stuffs your bank account while you're fast asleep. I have reason to suspect that my friend is in great financial shape and that his desire for passive income is based on the general premise that more income is better than less. (Shameless plug: to find out if you're in great financial shape, check out your Wealth Score!) But why passive income? The passive part of the equation I completely get.
After all, the real American dream is to make a shit ton of money while doing absolutely nothing.
However, the desire for more income should really only come from the need for more income. (Think retirees who have failed to save appropriately and are spending their days in a dinky rocking chair staring forlornly at pictures of their friends drinking margaritas in Florida.) For younger adults and well-off individuals, passive income should not be the focus for two main reasons: taxes and time. Instead, the focus should be on passive wealth. To evaluate the pitfalls of passive income in more detail, I'll break the argument into two contexts: investments and side-hustles.
Investments
When it comes to investments, your wealth can grow via income (e.g. interest payments, dividends, etc.) and appreciation (i.e. price increases). While it appears that you should be fairly indifferent to either option, income and appreciation aren't taxed the same way. Generally speaking, income is taxed more immediately and at a higher rate than appreciation, which is taxed only when the investment is sold and is done so at a lower rate assuming you hold it for more than 1 year. Under this tax structure, investing for passive income is nonsensical. In fact, there's a Netflix documentary (I don't remember what it's called, but Mark Cuban is one of the people interviewed) that highlights how rich people get even more rich by taking advantage of the tax laws by building wealth through appreciation rather than income. So for you brave souls out there wandering the fun house that is Dogecoin and reaping +600% gains in the process, enjoy your wealth boost because Uncle Sam isn't coming for you. Not yet, anyway.
Income
Besides investments, people also glamorize the process of making passive income via side-hustles whether it's owning rental real estate or selling cute wooden coasters. Note that for side-hustles to generate passive income, you shouldn't be doing much work. That's why it's called passive income.
The main problem is that building such a business that will make a positive dent in your financial life takes some serious time, money, and/or luck.
Not only do I know this from experience (yes, Moneyskope is still my side-hustle) but many other people I've spoken to and countless start-up podcasts have said as much. So the way I see it, side-hustles are extremely non-passive for a long amount of time, if at all. Therefore, pursuing a serious side-hustle is really only worth it if you enjoy a hobby that happens to make money, you want to change careers, you have the freedom to explore new paths to making money, or you're clinically insane. Otherwise, that time might be better spent in your current career where there's a path towards a promotion or something.
If you haven't noticed by now, I much prefer the path of growing assets by focusing more on passive wealth (i.e. price increases) rather than passive income. The tax laws make it much more advantageous to do so and there's generally less time involved, so long as you invest in some index funds and forget about them.