5 min read

what is residual income

Written By

Clay Shiffman

Residual income, often called passive income, is the net income that an individual continues to earn after completing the income-generating work. This financial concept is a powerful tool for building wealth and achieving financial independence, as it allows for a continuous cash flow without requiring active daily involvement.

Whether through investments, royalties, or ongoing business ventures, residual income provides a stream of earnings that can supplement or replace traditional wages, offering greater flexibility and freedom. Understanding personal residual income is essential for anyone looking to enhance their financial stability and create a sustainable income source that works for them long-term.

Defining residual income

Residual income, also known as passive income, is the money earned with minimal to no effort regularly after the initial effort has been expended. The income continues to flow into an individual's account even when they are not actively working for it. This type of income can stem from various sources such as investments, rental properties, royalties from intellectual property, dividend payments, and ongoing business revenues.

Unlike active income, which is earned through direct labor and active participation, residual income allows for ongoing earnings, providing financial stability and the potential for long-term wealth accumulation.

Understanding residual income for your personal finance

Understanding residual income is crucial for personal finance management, as it can significantly impact your financial stability and long-term wealth. Here's how:

  • Financial independence: Residual income provides a steady stream of earnings that doesn't require your constant active involvement. This can help you reduce dependence on a traditional paycheck and offer a safety net during unemployment or career transitions.

  • Wealth accumulation: By generating income from multiple sources, such as investments, real estate, or royalties, you can accelerate your wealth accumulation. This diversification can protect you against market fluctuations and economic downturns.

  • Time freedom: With residual income, you can free up your time to pursue other interests, hobbies, or even further income-generating activities. This balance can lead to a more fulfilling and less stressful lifestyle.

  • Retirement planning: Residual income is critical for a solid retirement plan. It ensures that you have a continuous income stream in your later years, reducing the reliance on savings alone and providing financial security.

  • Debt reduction: Extra income from residual sources can be used to pay off debts faster, reducing interest payments and freeing up more money for saving and investing.

  • Risk mitigation: Having multiple income streams can spread risk. If one source of income diminishes, others can help maintain your financial health.

To harness the power of residual income, consider exploring various avenues like investing in stocks or real estate, starting a side business, creating digital products, or acquiring intellectual property rights. By strategically building residual income streams, you can enhance your financial resilience and work towards a more secure and prosperous future.

Types of residual income

There are several types of residual income, each offering unique opportunities for generating ongoing revenue with minimal ongoing effort. Here are some common types.

Rental income

Investment income is derived from financial assets that generate regular earnings. Dividends are payments made by companies to shareholders out of their profits, offering a steady stream of income for investors.

Interest income comes from savings accounts, bonds, or other interest-bearing investments, providing a reliable return on capital. Capital gains occur when you sell stocks, bonds, real estate, and other investments at a higher price than their purchase cost, resulting in a profit.

Rental income

Rental income is earned from leasing out properties or assets. In the realm ofreal estate, this involves renting out residential or commercial properties, offering a consistent monthly income. Additionally, equipment leasing generates revenue by renting out machinery, vehicles, or other valuable assets to businesses or individuals who need them for a specific period.

Royalties

Royalties are payments received for the ongoing use of intellectual property. This can include intellectual property royalties from books, music, software, or inventions, where creators receive a percentage of sales or profits. Franchising also falls under this category, where business owners earn income by allowing others to use their business model or brand, typically in exchange for a percentage of the revenue or a flat fee.

Business income

Certain business models can generate residual income with minimal ongoing effort. Automated online businesses, such as e-commerce stores, drop shipping or affiliate marketing websites, require initial setup and maintenance but can provide continuous earnings.

Subscription services, like membership sites or software-as-a-service (SaaS) platforms, generate recurring payments from users who subscribe to access the services or content offered.

Peer-to-peer lending

Peer-to-peer lending platforms facilitate loans between individuals or businesses without traditional financial intermediaries. Investors in these platforms earn interest on the money they lend, creating a stream of residual income as borrowers repay their loans over time.

Licensing

Product licensing allows creators to earn income by granting others the right to manufacture, distribute, or sell their products. It can include product licensing for inventions or designs, where licensees pay royalties based on sales, providing the original creators with ongoing revenue without active involvement.

Calculating residual income

Calculating residual income involves determining the net earnings after accounting for the cost of capital. Here's a detailed explanation of the steps involved to calculate residual income.

  1. Identify net operating income (NOI): The first step is to determine the profit generated by the business or investment after deducting operating expenses and before taxes and interest. NOI equals your revenue minus the operating expenses.

  2. Calculate the cost of capital: Calculate the cost of capital, which is the required return on investment. It typically involves determining the weighted average cost of capital (WACC), which considers the cost of equity and debt.

  3. Determine the equity charge: The equity charge is the cost of equity capital for the period under consideration. It is calculated by multiplying the equity capital by the cost of equity.

  4. Calculate the residual income: Finally, use the residual income formula to subtract the equity charge from the net operating income.

Passive income vs. residual income

Passive income and residual income are often used interchangeably, but they have distinct meanings and implications in the realm of personal finance. Understanding the differences between the two can help in better financial planning and management.

Passive income

Passive income refers to earnings derived from activities in which the individual is not actively involved regularly. This type of income requires little to no daily effort to maintain once the initial setup is complete. Examples of passive income include:

  • Rental income: Earnings from renting out real estate properties, such as apartments, houses, or commercial spaces.

  • Dividend income: Payments from stocks or mutual funds that pay dividends.

  • Interest income: Earnings from savings accounts, bonds, or other interest-bearing investments.

  • Royalties: Payments for using intellectual property, such as books, music, or patents.

  • Automated online businesses: Revenue from e-commerce stores, drop shipping, or affiliate marketing websites that require minimal ongoing involvement.

Residual income

Residual income is a broader term that can refer to the income that continues to be earned after the initial effort has been expended. It is often used in different contexts, such as corporate finance and personal finance, each with a slightly different meaning:

  • Personal finance context: In personal finance, residual income is similar to passive income but emphasizes the ongoing nature of the earnings. It is the income remaining after all personal debts and obligations have been met. For example, royalties from a book continue to provide residual income after the book has been published.

  • Corporate finance context: In corporate finance, residual income is what a company generates after accounting for the cost of capital. It measures the net operating income minus the equity charge. This calculation helps assess the company's profitability and the value created beyond the minimum required return.

Key differences

Passive income is generally more associated with minimal active involvement, whereas residual income focuses on the ongoing nature of income streams, whether they require some ongoing effort or not.

Passive income is primarily used in personal finance to describe income that doesn’t require active work. Residual income can be used both in personal finance and corporate finance, with the latter emphasizing income after capital costs.

Passive income is straightforward and refers to earnings from passive sources. Residual income, especially in corporate finance, requires specific calculations involving net operating income and cost of capital.

Tax implications of residual income

Understanding the tax implications of residual income is crucial for effective financial planning and maximizing after-tax returns. Here are the primary tax considerations for various types of residual income:

  1. Eligible dividends: These are dividends paid by Canadian corporations eligible for a dividend tax credit, which lowers the effective tax rate for individuals. Eligible dividends are grossed up by 38%, and then a federal dividend tax credit of 15.02% of the grossed-up amount is applied.

  2. Non-eligible dividends: These are typically paid by small businesses and are subject to a lower gross-up rate of 15% and a smaller dividend tax credit of 9.03%.

  3. Rental income: Rental income is taxed at your marginal tax rate. You can deduct expenses related to the rental property, such as mortgage interest, property taxes, insurance, repairs, and maintenance, which can reduce the taxable amount.

  4. Capital gains: Capital gains from the sale of investments like stocks or real estate are only 50% taxable in Canada. This means that only half of the capital gain is added to your income and taxed at your marginal tax rate. If you sell a property that was your principal residence, the capital gain is generally tax-exempt.

  5. Interest income: Interest income from savings accounts, bonds, or peer-to-peer lending is fully taxable at your marginal tax rate. This means that there are no preferential tax treatments or credits for interest income, making it one of the least tax-efficient forms of income.

  6. Royalties: Royalties from intellectual property, such as books, music, patents, or franchise agreements, are considered regular income and are taxed at your marginal tax rate. Expenses related to generating this income can be deducted to reduce the taxable amount.

  7. Interest income from bonds: Interest from bonds is generally taxed as ordinary income. However, interest from municipal bonds is usually exempt from federal taxes and may also be exempt from state and local taxes if you live in the state where the bond was issued.

  8. Annuities: Annuity payments are split into two components: a return of capital portion, which is not taxable, and an interest portion, which is taxable as regular income. The tax treatment depends on whether the annuity is registered (like an RRSP annuity) or non-registered.

  9. Tax-advantaged accounts: Using tax-advantaged accounts can help reduce the tax burden on residual income. Income earned within a Tax-Free Savings Account (TFSA), whether from dividends, interest, or capital gains, is not taxable. Contributions are tax-deductible, and the income earned within the Registered Retirement Savings Plan (RRSP) is tax-deferred until withdrawal, typically at retirement when you may be in a lower tax bracket.

Why is residual income important?

Residual income holds significant importance for both personal financial stability and long-term wealth building due to several key reasons:

  1. Financial independence: Residual income provides consistent stream earnings even when you are not actively working. This independence from traditional employment income can offer greater financial security and stability, especially during economic downturns or unemployment.

  2. Diversification of income streams: Diversification helps mitigate the risk associated with relying solely on a single source of income, such as a salary from a job. Different types of residual income can vary in their sensitivity to economic cycles, providing more stability overall.

  3. Flexibility and freedom: Residual income allows flexibility in allocating time and resources. Once established, residual or passive income streams often require less ongoing effort than active income sources. This freedom can enable you to pursue other interests, spend more time with family, or explore new ventures without financial constraints.

  4. Wealth accumulation: Residual income contributes significantly to wealth accumulation over time. Income generated from residual sources can be reinvested into other income-producing assets or used to pay down debt, accelerating wealth growth. Over the long term, compounded residual income can lead to substantial financial independence and wealth creation.

  5. Retirement planning: Residual income is valuable for retirement planning. It provides a reliable source of income during retirement years when traditional sources of income may no longer be available. Building up residual income streams early in life can ensure a comfortable retirement with sufficient funds to maintain desired lifestyles.

  6. Passive in nature: Residual income is often passive or semi-passive, meaning it requires less active involvement once established. It allows individuals to earn income without the continuous time and effort demanded by traditional jobs. It can serve as a hedge against job loss or unexpected life events that impact earning potential.

  7. Sustainability and longevity: Residual income tends to be more sustainable and enduring compared to active income, which is tied directly to ongoing work efforts. Assets that generate residual income, such as investments, rental properties, or royalties, can continue to produce earnings over extended periods, providing ongoing financial security and peace of mind.

Building a residual income stream

Building a residual income stream involves strategic planning and investment in income-producing assets that continue to generate earnings over time with minimal ongoing effort. Here’s a step-by-step guide to building a residual income stream:

  1. Set financial goals: Define your financial goals and objectives. Determine how much residual income you aim to generate and over what timeframe. Having clear goals will guide your investment decisions and keep you focused on achieving sustainable income.

  2. Identify suitable income sources: Explore various types of residual income sources that align with your financial goals and risk tolerance.

  3. Conduct research and due diligence: Thoroughly research each income source to understand potential risks, expected returns, and management requirements. Consider consulting with financial advisors or experts in each area to gain insights and minimize investment risks.

  4. Invest and build assets: Allocate your resources strategically across chosen income streams. Diversify your investments to spread risk and optimize returns. Start with a manageable investment amount and gradually increase as you gain confidence and experience.

  5. Monitor and manage investments: Regularly monitor the performance of your investments and income streams. Stay informed about market trends, economic conditions, and regulatory changes that may impact your investments. Adjust your strategies as necessary to maximize returns and mitigate risks.

  6. Reinvest and grow: Reinvest a portion of your earnings back into your residual income streams to enhance growth. Compound interest and reinvestment can accelerate the accumulation of wealth over time. Continuously seek opportunities to expand your portfolio and explore new income-generating avenues.

  7. Maintain financial discipline: Practice disciplined financial management by budgeting, saving, and controlling expenses. Maintain adequate liquidity to cover unforeseen expenses and to capitalize on new investment opportunities.

  8. Seek professional advice: Consider seeking advice from tax advisors, financial planners, or investment professionals to optimize your residual income strategy and ensure compliance with tax laws and regulations.

  9. Stay committed to goals: Building a residual income stream requires patience and persistence. Stay committed to your long-term financial goals, and be prepared to adjust your strategies as market conditions evolve. Celebrate milestones and achievements along the way to maintain motivation.

Keep your residual income safe and manage finances effectively with KOHO

Whether you need financial plans for spending or saving, KOHO has many products to help keep your residual income secure so you can spend it whenever you want. From a debit or credit card for Canadians to a high-interest savings account (HISA) or overdraft protection coverage, you have options and tools to make your various financial goals a reality.

For example, you can sign up for a virtual credit card to build your credit with KOHO and strengthen your creditworthiness. Ensure you understand the pros and cons of a credit card so you can use it responsibly to make purchases. You can also request a free credit score report to monitor your credit-building progress.

The KOHO prepaid card has many benefits, helping you with budgeting, ensuring you stay within your spending limits, and teaching you healthy spending habits. Whether you're looking for credit or debit cards to build credit and strengthen your credit profile, we've got your back.

Note: KOHO product information and/or features may have been updated since this blog post was published. Please refer to our KOHO Plans page for our most up to date account information!