How To Use Passive Income To Supplement Retirement Income

For many people, retirement comes with a sudden drop in earnings. If you're looking for ways to supplement your monthly cash flow, passive income is one option. Passive business activities bring in extra revenue without the time demands of a full-time job — it can be a great way to earn money and stay engaged, all while leaving plenty of time for fun and relaxation.

What Is Passive Income?

"Passive income" is a term that's used to describe a wide range of activities in which you earn money from a business without being actively involved. It's a way to earn money without trading your time.

It's important to note that the colloquial definition of "passive income" is different from the Internal Revenue Service definition.

IRS Definition of Passive Income

In the eyes of the IRS, there are just two business activities that qualify as passive:

• Businesses or trades that don't require your material participation
• Rental activities, as long as you're not a real estate professional

What counts as material participation? According to the IRS, you participated materially if your involvement is "regular, continuous and substantial."

Let's say you bought into a business in return for a share of the profits. If you let the other owners run the show, your income is passive. If you're actively involved in running the company, your income is probably classified as active. To make the determination, the IRS uses a set of material participation tests that include: 

• Participating for more than 500 hours
• Participation that makes up all or most of the activity in the business
• Participating for 100 hours if that's at least as much as other people who are involved

Rental activities don't need to meet material participation tests to qualify as passive. However, they may not be passive if they meet conditions such as:

• The average rental period is 7 days or less
• The average rental period is 30 days or less, and you offer a significant amount of personal, individual service
• You offer personal services that the IRS considers "extraordinary"
• Your main purpose in owning the property is to achieve financial gain from appreciation

In some cases, the IRS also treats self-charged interest as passive income or a passive activity deduction. This usually happens when money is loaned between you and a partnership or an S corporation or between partnerships and S corporations.

Tax Implications for Passive Income

Why does it matter if your income stream is passive or active under IRS rules? The IRS may treat passive income differently when it comes to taxes. In some cases, it's included in your standard income. If you record a loss on one of your passive activities, you may be able to use credits or take deductions of up to $25,000. The rules about deductions are complicated, so it's a good idea to consult with a tax professional to minimize your tax liability.

Other Types of Passive Income

The IRS' concept of passive income is just one way to think about passive income — the entrepreneurial world tends to use a looser definition. In this case, passive activities could be any type of business endeavor that brings in money without requiring much effort on your part. For example, you might earn passive income through affiliate marketing or selling online courses.

Passive income, by any definition, is rarely passive. Rather, many "passive" activities require you to front-load the bulk of the work; then, you can let the business run on its own without much of an ongoing effort.

If you're a graphic designer, you might open a store on Etsy selling downloadable digital products. Once you design a product and put it in the store, it can sell an unlimited amount of times — the system handles orders, payments and file delivery on your behalf. This type of income feels passive because you put the work in once and profit indefinitely.

Ways To Make Passive Income

If your retirement finances could benefit from extra cash, you can earn passive income in many ways. The earlier you start, the easier it will be to maintain a steady, predictable income down the line.

Limited Partnerships

Limited partnerships are among the most passive types of passive income. You'll invest in a business as a limited partner in exchange for a predetermined share of the earnings. The general partner handles the operation of the business and shoulders the bulk of the liability. Typically, your liability is limited to the amount you invested. 

Rental Property

Rental property is a popular type of passive income because it generates a predictable profit each month. You can purchase separate investment properties, rent out guest suites or add an outbuilding to your property to use as a rental. If your properties fit the IRS' rules for passive activities, you may qualify for deductions.

Rental Vehicles or Equipment

Renting out vehicles and equipment comes with risk, but with the right policies and insurance, you can minimize potential losses and turn a reasonable profit. Consider renting out heavy equipment, RVs or personal vehicles. Platforms such as RVShare and Turo automate the process and reduce your workload.

Online Businesses

Online businesses are an increasingly popular way to earn passive income. They can also be a fun way to learn new tech skills in retirement. The beauty of online businesses is that they adapt to your budget, location and time availability. Some options to investigate include:

• Websites that earn money with ads and affiliate commissions
• Online courses on platforms such as Teachable or Udemy
• Online stores on marketplaces such as Etsy
• Drop-shipping or Fulfilled By Amazon stores
• Self-published books that sell on the Amazon Kindle store

Licensing Deals

If you're a photographer, videographer, musician or artist, you can make passive income through licensing deals. Once you create a piece of content, you can make it available to companies who want to use it in their own projects.

Artists, for example, can license illustrations and paintings for use on home decor, water bottles, stationery and other consumer products. If you shoot a video, you might license it to companies for use in commercials, TV shows and movies.

Do Investment Withdrawals Count as Passive Income?

Traditional investment income isn't typically considered passive income. You may earn money from annuities, investments and high-yield savings accounts, but the IRS doesn't view it as passive income.

Are There Risks to Passive Income Streams?

There are risks to most types of passive income. If you invest in a limited partnership, for example, the business could go under. Likewise, a renter could damage your property or crash your RV. Online businesses often have minimal risk, given the low financial investment, but a single change to the Google algorithm could reduce your revenue overnight.

Passive income streams usually take work — perhaps more than you want to commit to in retirement. Income can also be variable, making planning a challenge. If you do your research and take steps to mitigate risk, however, they can help you maintain a comfortable standard of living after you retire.