Generating a large passive income stream is a financial goal shared by many. After all, who doesn’t love the idea of watching money magically appear while doing nothing?
There are many different ways to build a passive income, each with its own advantages and disadvantages. So, let’s go through some of the most popular methods of reaching financial independence used by investors today.
What is passive income?
The idea of passive income is to invest either time or capital to establish a reliable, steady source of money. While this process initially requires some dedication, the objective is to make it self-sustaining in the long term. That way, the money keeps flowing without having to lift a finger beyond keeping an eye on things.
There are lots of ways to go about building a passive income. Some people start a business or try making money online through affiliate marketing. But there are plenty of alternatives for investors who can’t or are don’t want to going down this route.
Top 6 passive income ideas in the UK
Let’s go through our list of top passive income streams in order of risk and return.
1. Dividend stocks
Not all companies are high-flying growth enterprises. Some of the most prominent industry leaders have long surpassed their growth phase as they matured. But while these businesses can often be boring, they can be a tremendous passive income investment.
Companies with a stable and reliable cash flow may decide to return capital to shareholders if they can’t reinvest it internally. There are various mechanisms in place to do this. But dividends are by far one of the most popular.
The dividend income received is tied to the number of shares owned. So, the larger the position an investor has, the more money they’ll receive. Here in the UK, the average yield from dividend shares stands at around 4% annually. However, there are companies that offer a higher return.
Earning money for just owning shares sounds rather lovely. But there is a caveat. Dividends are paid from a company’s pool of excess capital generated by cash flows. Yet dividends may become compromised if anything disrupts revenue or earnings. And since these are optional payments, they can be cut or even cancelled on short notice.
This is precisely what happened to many once-thriving industry titans during the 2020 pandemic. Furthermore, stock prices tend to tumble once the passive income stream is no longer viable. This means it’s possible to destroy wealth rather than create it.
2. Mutual funds and index trackers
Dividend shares can be lucrative. But an investor needs to know how to identify strong businesses capable of delivering long-term sustainable income. Needless to say, that’s easier said than done. Fortunately, investing in a fund or index tracker can pass this process to a professional.
A mutual fund pools the money from thousands of different investors into a single pot, which can then be invested into a wide range of companies by an investment manager. The manager takes care of stock picking, diversification, and portfolio construction on behalf of all the investors in exchange for an annual fee.
In the meantime, any dividends received will either be paid out to shareholders or reinvested back into the portfolio to increase the value of the fund’s shares.
Index trackers work in a similar way, except that the pool of funds is invested in replicating an underlying index. For example, a FTSE 100 index fund will invest shareholders’ capital exclusively into the stocks found inside the FTSE 100 index.
This enables investors to easily replicate the performance of the general stock market, handing all the management responsibilities to a professional. And since most index funds are actually run by computers, the fees tend to be significantly lower than those of mutual funds.
However, the passive income is still derived from dividends and can be disrupted.
3. Investment Trusts
As a passive income idea, investment trusts have a lot of similar characteristics to mutual funds and index trackers. In fact, they work almost identically. However, the critical difference is the cash reserve policy.
An investment trust can retain up to 15% of the annual income from its various investments as cash on the balance sheet. And this can actually be quite advantageous for shareholders.
Why? Because if the stock market goes through a period of volatility as it has done in 2022, dividend payments are often interrupted. However, an investment trust can use its built-up cash position to continue offering an attractive yield to shareholders even if the source of that passive income is cut off.
The idea is to have enough cash in reserves to keep distributing income to shareholders until dividends from the portfolio have been restored. That’s why these types of investments can often be found on top-performing dividend lists.
But once again, investment trusts aren’t free from risk since the cash reserve can eventually run out depending on how severe the situation becomes. Not to mention that if the management team cannot identify winning stocks to buy, the return on investment could be poor.
4. Real estate
Investing in a rental property has been an immensely popular passive income idea for decades. And providing that the costs of maintaining a property (including the mortgage) are lower than the income generated, this approach can be pretty lucrative.
Furthermore, even when the economy is wobbly, rental income isn’t as adversely affected as regular dividends since people still need a place to live.
However, as many will know, getting a mortgage isn’t exactly cheap. And with interest rates now on the rise, the cost of taking this approach is rising. Not to mention all the headaches of dealing with tenants, especially those that don’t pay rent on time.
Fortunately, there is an alternative form of real estate investing that generates a similar level of passive income and overcomes these issues. Enter the real estate investment trust (REIT).
A REIT pools together investors’ money much like any other fund or trust. It then invests this capital into a portfolio of real estate assets, returning the rental income to shareholders as a dividend.
All the hassle of dealing with tenants and property maintenance is handed over to the management team, who charge an annual fee for their services. And it also enables individuals to invest in commercial real estate properties such as car parks, hospitals, shopping centres, and warehouses with more reliable tenants.
5. Income bonds
The examples given so far are all a form of equity. But what about debt? With bonds, investors can buy government or corporate debt and receive interest on it as a form of passive income.
What’s more, unlike dividends, interest payments on loans are mandatory, improving their reliability during business down periods. That’s why these instruments are often considered significantly less risky than equity.
However, that doesn’t mean the risk level is zero. After all, an investor holding corporate bonds in a company that goes bankrupt isn’t likely to receive a good return on investment.
Fortunately, the bond rating agencies make the process of finding good quality debt relatively easy. But it’s worth noting that the higher-quality bonds often offer the lowest interest income.
On average, fixed-rate investment-grade five-year income bonds offer an annual interest rate of around 3%.
6. Savings accounts
A savings account arguably offers a near-risk-free passive income stream. Banks take deposits to fund lending activities to individuals and businesses alike. They profit from the interest charged on the loans and return some of that profit to their depositors in the form of interest on their total balance.
Commercial banks are highly regulated, with many protections are in place to prevent a financial institution from becoming over-leveraged. In the UK, the Financial Service Compensation Scheme (FSCS) protect cash deposits up to £85,000 for a sole account and £170,000 for a joint account.
However, the return on cash deposits vs. money invested over the last decade has stood close to 0% due to exceptionally low interest rates. In other words, this stream of passive income doesn’t exactly generate a meaningful return.
Frequently Asked Questions
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Generating a passive income enables investors to slowly accumulate wealth that, in turn, creates more wealth. The compounding effect takes time to become established, and numerous threats seek to disrupt it. But in the long term, building a passive income for the future can be highly lucrative.
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In most cases, yes. However, there are some strategies available to reduce or even legally avoid paying taxes altogether.
For example, the Stocks and Shares ISA trading account allows individuals to invest up to £20,000 per tax year into the stock market with all dividend income and capital gains protected from taxation.