How to generate $100,000 in passive income

Compounding is one of the most powerful forces in investing. I recently wrote an article offering some lessons on compounding for investors that want to harness this power to achieve their goals.

The article led to some questions from readers asking how compounding works for investors that have a goal of generating passive income. Luckily it doesn’t take a lot of prompting for me to writing about income investing.

This article outlines the basics of generating and growing passive income. I’ve centred this analysis around a goal of generating $100,000 in passive income. This may seem impossible for many readers but with time and focus it is achievable for some investors. Passive income can benefit all investors even if a six-figure goal is out of reach.

How compounding works when building passive income

Many of the tenets of my first article on compounding apply and I recommend reviewing it prior to reading this article. When the goal is generating passive income compounding works a little differently. A focus on growing the value of a portfolio involves three components that impact total wealth in the future - time, returns, and new savings.

Building passive income involves combining time, dividend growth, dividend reinvestment and savings. I am going to use similar tables as the first article to break down each of these components.

The first component to expore is the impact of savings. This is new money that is saved and used to purchase income producing assets. This first scenario assumes there is no dividend growth and no reinvestment of dividends.

In many ways this approximates investing in income producing assets that do not grow their income stream. This includes term deposits and most bonds where payments are fixed until maturity. Once a bond or term deposit matures an investor is at the mercy of the current interest rate environment. This is known as reinvestment risk.

This article focuses on share investing. The advantage of dividends is that they can grow over time if a company is able to grow earnings and has the desire to pay higher dividends. Over long-time horizons shares offer the best opportunity to grow passive income.

The following table assumes that $10,000 is invested each year for 40 years. The $10,000 is invested into an income producing asset that has a 4% yield. That means that $400 of passive income is effectively ‘bought’ each year.

Total passive income grows from zero to $16,000 at the end of the 40-year period. It is important to note that compounding plays no role in this table because I’ve excluded any dividend growth or the impact of dividend reinvestment.

This table does have an important lesson for income investors. Over time new contributions into your account will matter less as overall passive income grows. We can see this in the far-right column that shows the percentage of income growth from each contribution. In the second year it is 100% growth and in the last year it is just above 2.5%.

Compounding is a critical factor in growing wealth and passive income. Investors should focus on buying growth assets like shares as early as possible. Time in the market matters and it is very unlikely that an investor can ‘save’ their way out of a delay later in life.

In the next table I’ve layered in another component of passive income growth. The income earned each year has now been reinvested at a 4% yield. This is dividend reinvestment. It can either be done through a formal reinvestment plan which buys the same shares, funds or ETFs or by collecting income to invest in other income producing assets.

This starts to demonstrate the impact of compounding. Reinvesting a growing income stream compounds over the 40-year period. The total passive income stream generated after 40 years has increased by 137% from $16,000 to just over $38,000.

In the next table I’ve added in dividend growth. I’ve assumed 5% dividend growth over a 40-year period. I believe this is a reasonable estimate for a global dividend portfolio. The average dividend growth for shares in Australia has been 3.70% a year over the last 10 years. The S&P 500 has grown average dividends per share by 7.82% a year over the same period.

Dividend growth turbo charges compounding. Not only is there a new source of growth through increases in dividends but the impact of dividend reinvestment increases over time. Dividend growth leads to higher amounts to reinvest which means owning more shares which benefit from future dividend growth.

The total passive income stream has increased by 292% from the roughly $38,000 in the previous scenario. An investor following this approach would end up with a $149,000 income stream from total contributions of $400,000. That is an implied yield of over 37% on what was saved and invested over the 40-year period. This represents one of the most important metrics in income investing which I’ve outlined in my article on yield at cost.

This again demonstrates how over time the portion of income growth attributed to new savings drops. In this case the largest portion of income growth comes from dividend increases by the end of the 40-year period. That is because the assumed 5% growth rate in dividends exceeds the 4% yield obtained from dividend reinvestment. This represents the trade-off between higher yields and dividend growth. More on this point later.

The last scenario includes the impact of franking credits. Franking credits are available for Australian investors that invest in Australian shares. This includes Australian shares owned through funds and ETFs. A well-diversified portfolio should include both local and global shares. Historically local shares have offered higher yields but slower dividend growth and more variability in dividends. That is why I assumed a global portfolio in my estimate of 5% dividend growth.

Franking credits are used to prevent the double taxation of dividends. As a shareholder an investor is an owner of a business. The business pays taxes on income earned. When a portion of that income is passed along to a shareholder in the form of a dividend it is taxed again. Franking credits make up for this double taxation. The franking credits can offset other taxes owed or are cash payments to shareholders if they exceed total taxes owed.

To be conservative I’ve assumed a .50% per year yield boost from franking credits. The ATO releases a monthly franking credit estimate for the ASX All Ordinaries and over the past year it was 1.46%. I’ve chosen to be conservative given my advocacy for a global portfolio to increase dividend growth.

The impact of a grossed-up yield of 4.50% brings the total passive income generated to just over $194,000. Not too bad.

How to generate $100,000 in passive income

The scenario outlined above significantly exceeds the $100,000 target over 40 years when new savings, dividend reinvestment, dividend growth and franking credits are all accounted for. This is a nice outcome on a spreadsheet but in the real world we need to account for taxes and the fact that many investors won’t have 40 years to invest.

The following table includes a 15% annual tax on dividends. In Australia that can be achieved by holding assets within superannuation. The assumption is that the taxes are paid out of the amount available for dividend reinvestment.

Even after adding in taxation on super the total passive income generated significantly exceeds our $100,000 target.

In the next scenario I used a marginal tax of 45% which all taxpayers earning more than $200,000 will pay once the tax cuts come into effect at the end of June 2024. In this scenario an investor is still able to create a passive income stream over $100,000 by the end of the 40-year period.

Applying this tax rate over the 40-year period is conservative Most people experience varied marginal tax rates over their lifetime as salaries naturally increase with age.

This scenario shows that even at the highest marginal tax rate an investor can generate over $100,000 in passive income by saving $10,000 a year, investing at a grossed-up yield of 4.5% including franking credits, reinvesting dividends, and experiencing 5% dividend growth.

How to generate $100,000 in passive income over 20-years

I’ve used reasonable assumptions in the previous scenarios. For many readers I’m sure one jumps out – the 40-year time frame. Time is the biggest enabler of growing wealth and passive income. And while we all wish we had come to this realisation earlier in life many investors don’t get serious about investing until some of the precious resource of time has ticked away.

I’ve created a shorter scenario of 20 years to show how to get to the $100,000 goal for passive income with less of a runway. This is a more challenging endeavour and the changes I’ve made in the inputs reflects this reality.

In the superannuation scenario with a 15% tax rate on dividends I have adjusted the yield from 4.50% to 5.50% inclusive of the impact of franking credits. This is harder but achievable if an investor tilts a portfolio towards higher yielding domestic shares.

Investing is about trade-offs and often higher yielding shares grow dividends at a slower pace. We have seen this effect in the Australian market. The higher yields are often an indication that the company has less opportunities to grow and therefore returns more cash to shareholders. Allocating a high amount of cash flow to dividends can also limit the funding for growth opportunities. To account for this trade-off, I lowered the dividend growth rate to 4%.

The largest adjustment needed is to annual savings. There is no getting around the fact that more needs to be saved if the timeline is halved to 20 years. In this case annual savings is increased to $35,000.

This again demonstrates that the power behind compounding is time. The time was reduced by half and 3.5 times more needs to be saved to reach an outcome of $60,000 less per year in passive income under the same tax scenario. The lesson as always - start early.

To reach the same outcome at a 45% marginal tax rate is more challenging. Leaving dividend growth at 4.00% and the yield at 5.50% requires saving $42,000 a year. This demonstrates the benefit of minimising taxes.

Lesson 1: Trade-offs matter in income investing

The trade-off between higher yields and dividend growth is an important consideration for income investors. We can use the original 40-year scenario to explore how this works. Increasing the yield on the portfolio by 1.00% to 5.00% results in the same amount of passive income at the end of the 40-year period as reducing the annual dividend growth rate by 1.74% to 3.26%.

Those trade-offs will vary with different investment timelines but it provides some guidance as investors make decisions when selecting individual holdings in a portfolio.

Franking credits undoubtably influence decision making by Australian investors. And they should - they are valuable. Yet their value can be quantified and there are cases when a global company without franking credits is a better choice for an investor.

Don’t forsake dividend growth just for franking credits. A diversified portfolio with a mix of higher yielding shares with less opportunity for dividend growth and lower yielding shares with higher potential dividend growth can be the best approach for growing passive income.

Lesson 2: Keep your focus on the future

I recently wrote about four mistakes that income investors make. One of those is dividend traps. The issue with using the dividend yield to decide what shares to buy is that a yield is based on what has happened in the past. As investors we only care about what happens in the future. The key to success is finding sustainable dividends that grow in the future.

Lesson 3: Increase the bang for each buck of savings

I’ve previously mentioned an article I wrote that explored my favourite metric to track the success of my income portfolio – the yield at cost. I like this metric because it shows me exactly how much passive income I am generating off of money I saved and invested in the past. I simply divide how much income a particular position or my portfolio as a whole generates by the cost basis of the shares and ETFs I own.

Dividends grow and the yield at cost goes up. Dividends are reinvested and the yield at cost goes up. It is another way of seeing the tangible benefits of compounding.
The following table shows the yield at cost of each of the scenarios explored in this article and the compounded annual growth rate ("CAGR") of total passive income. This is the magic of compounding.

Final thoughts

The conclusions don’t differ from my original article on compounding. While the components in growing passive income are slightly different the key factor remains time. That is why successful investing involves patience and consistency.

Many investors come to that conclusion too late in life. Too many of us are attracted to investing by the siren song of instant riches. This impatience to get rich quick is reflected in our actions. Constantly jumping to each shiny new investment opportunity while time ticks away.

I like the concept of building passive income because it keeps me focused. Saving and investing $1000 results in something tangible - $40 of extra income assuming a 4% yield. Maybe that is just me. I know that $40 may not seem like a fair trade-off for $1000 of hard-earned money. Yet it works for me. Each investor needs to find their own path to benefit from the power of compounding.

I want to hear your questions and experiences in investing for income. Email me at mark.lamonica1@morningstar.com and I will send you a spreadsheet where you can adjust the different components of income investing to chart your path to $100,000 in passive income and beyond.

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