The Real Cost of Passive Income

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Many of our clients come to us with questions about whether they should consider investing in some form of income-generating asset to secure some highly coveted “passive income”. Examples include securities that pay steady interest or dividends, or real estate to provide rental income.

The short answer is: well, it depends on your situation.

Take a step back and ask, what is the purpose of this investment? To grow capital? To protect capital? Will I need to withdraw cash in the near future?

Ultimately, there is no such thing as a free lunch, and you as an investor are paying for the convenience and comfort of an income-generating asset. That payment comes in the form of lower average returns relative to capital markets in the case of real estate, and total returns lower than those of growth oriented investments in the case of dividend paying stocks. If you are still working and earning a paycheck, do you really want your investment returns in the form of income? Because there are two issues here: 1: You will be paying a hefty and immediate tax on this income (tax on interest, dividends, and rental income are often at your current income tax rate). If you are already in a high income tax bracket, then it basically means your investment returns could get chopped in half before it even hits your bank account. Despite this, we constantly see higher-rate taxpayers in Japan on the hunt for passive income. Then we have problem number 2: How to reallocate this capital. You have accumulated some cash from these income-generating assets, and don’t want to blow it all on an expensive vacation; so what to do with it now? Again, there’s no such thing as a free lunch, and it will in some way or another cost you to then reinvest this cash.

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Instead, if you do not require an income generating asset, then why pay for it? For example, investments in capital market funds may not provide you the comfort of an income; but again, if you don’t need it, why pay for it? You as an investor are compensated in the form of higher average returns, and the returns themselves are in the form of capital appreciation, thus staying invested.  There are 2 big benefits here: 1: Because the returns through capital appreciation stay invested, there is no taxable event until you ultimately liquidate many years down the road. And 2: Once you do liquidate, capital gains tax is substantially lower than tax on dividends and rental income- particular given that Japan treats investment sourced income in exactly the same way as ordinary employment-sourced income.

So When Do Income Producing Investments And Passive Income Strategies Make Sense?

Once you do approach retirement age, income-generating assets start to make more sense. Perhaps your annual salary will have decreased, or ceased entirely if you are fully retired.  This means you’ll be back at the bottom income tax bracket, and any investment returns through income-generating assets will be taxed at a substantially lower rate than before.

Not being able to afford the potential volatility of capital markets, and happy to accept slightly lower yet steady returns, it then may make sense to transition substantial portions of your portfolio into income generating assets. Before then, be aware that a good percentage of your earnings as an income-focused investor will end up going to the Japanese tax man.

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Sources and Further Reading