In order to plan for and achieve financial independence ( FI ) we will need to understand the different ways in which we can generate income for ourselves. In broad terms we can categorize income into two categories – Active income and Passive income. Achievement of FI will depend primarily on the adequacy of passive income, so we need to understand it well.
Let us first look at Active income. It is the income that we earn from our job or profession or business. It involves spending our time to create something of value to other people, who are then willing to pay for the same. For example, you may be in a job that is giving you a regular salary. Here you are spending time at your workplace and doing something useful and productive for your employer. In exchange of that your employer pays you a regular monthly salary. This is completely dependent on your spending time at work – if you decide to stop going for work then the salary would also not be there.
Let us see some other examples of Active income in order to understand this a little better:-
- Consultation fees earned by professionals such as Doctors, Lawyers , Tax consultants etc.
- Training revenues earned by a consultant when he conducts private or public workshops.
- Income earned out of trading in the stock market by a trader.
- Profits earned by a small scale business person out of his neighborhood grocery shop.
- Commissions earned by an LIC agent from the policy that he has sold recently.
- Profits earned out of active management of your stock portfolio.
The key criteria is, as you can see, the income being generated out of the time that you are spending today. As a contrast to this, Passive income is something that you earn without having to spend current time. A perfect example will be rent earned from a property that you own. At some point of time you had acquired the property and made efforts to get a tenant. However, now the rent comes every month without having to do much about it. Some other examples of Passive income are :-
- Dividends earned out of your investments in Stocks and Mutual Funds.
- Interest earned out of Tax-free bonds and other similar instruments.
- Trailing commissions earned out of LIC policies and Mutual funds sold in the past.
- Any kind of pension or other annuities earned on a regular basis.
- An author or singer earning royalties out of past work.
- Unexpected windfall from an inheritance !!
In order to achieve FI a primary condition is that our Passive income must be adequate and sustainable for all our financial needs. In a state of Financial independence, there is absolutely no bar on earning Active income by either continuing your existing activity or by doing something new altogether. However, if your financial requirements need access to the Active income then you are not Financially independent.
It is therefore easy to see that all of us should strive to be financially independent as soon as possible. People confuse it with early retirement but this is completely two different things, except that you cannot go for an early retirement unless you have achieved FI.
In the next post we will see the different uses of money that we have in a normal state and how the spending dynamics should logically need a change in our state of FI.