Index funds are a great way to grow your wealth, and are touted by some of the best investors in the world. Not only can index funds increase your net worth, they can also help you build passive income.
Index funds provide passive income directly through dividends, and indirectly through growth that can be withdrawn as cashflow. Depending on the index fund, it can pay dividends in the form of cash on a monthly or quarterly basis. You can also sell shares of the index fund to create passive income.
Not all index funds are created equal, but they can be a great tool to create passive income. Read on to learn more about how index funds can fit into building passive income.
Do You Get Passive Income From Index Funds?
Whether or not you categorize it as passive income, index funds are a great way to passively increase your wealth.
In general, index funds will pay a dividend. The index fund will distribute any dividends paid out by the stocks on that fund. So unless the stocks held in the fund have no dividends, the fund will pay a dividend on a recurring basis.
Now as mentioned, I would say index funds are better suited for passively creating wealth, rather than creating passive income. You can purchase index funds that are targetting dividend income, but you’ll also benefit from the growth in your investment. For example, the S&P 500 has returned 10% on average in growth. This growth will largely be in the value of the fund, but also includes the dividend income.
Ultimately, it’s possible to create passive income using index funds.
What are the Different Ways Index Funds Create Passive Income?
Index funds can create passive income directly through dividends, or indirectly through a passive increase in the value of your investment. Index funds are a truly passive investment choice, as once you purchase, there’s little to no maintenance.
Dividends
In general, index funds will pay a dividend. Index funds typically track an index (e.g. S&P 500), and hold the stocks listed on that index. Any dividends issued by the stocks the fund holds are then passed onto the fund holders. There could be cases where an index does not have any stocks that issue dividends, but for majority of indexes will have stocks that issue dividends.
The dividend can be withdrawn and used as income to fund your lifestyle. It can also be used to purchase more shares of the index fund so you get even more dividend the next quarter, increasing your wealth exponentially.
The way to tell if an index fund issues a dividend is to go to its information site, and look for “Distribution” information. This will outline how often, and how much dividend the fund pays. E.g.:
The distribution or dividend yield will depend on the index fund and the companies the index tracks. For example, the S&P 500s yield has varied a lot over the years, from over 5% in the early 70s and 80s, to below 1.5% as of the writing of this article. This is likely due to the increased concentration of fast growing tech stocks that don’t pay dividends:
The dividend however is only one part of the equation, and the growth in the value of your investment should also be considered.
Passive Growth in Wealth
The other side of index funds is the growth in value of the shares. Now the growth will not be linear, but over time index funds generally have increased in value.
This growth does not directly correlate to passive income in the form of cash flow, but as the value of your portfolio grows, you can sell a small portion on a regular basis to create passive income.
Let’s imagine that you had $200,000 invested and it was returning 10%. That would mean that your return would be $20,000. You could sell a portion of that, for example $5,000 worth, and use that to fund your lifestyle.
In fact, there is a common investment rule of thumb called “the 4% rule” that states that you can safely withdraw 4% of your portfolio value each year and have your savings last 30 years or more. Now this is a simplification, and more reading is recommended. But this shows how investing in index funds can create a base to be able to withdraw a passive income for your retirement.
The consideration with withdrawing for creating passive income though is that each withdrawal will reduce the value of your investment. Unlike investments like real estate where getting cashflow doesn’t impact the value of your asset (the property), withdrawing from your investment account is slowly killing your golden goose.
Is the S&P 500 a Passive Income Fund?
The S&P 500 is not directly a passive income fund and is better suited for passive wealth growth. The reason for this is that the dividend is relatively small (~1.5% as of this writing), and most of the return is going to be in the growth of the fund’s value.
That said, as noted above, using the 4% rule you can use the S&P 500 growth to create passive income. This would be done by selling a portion of your holdings of the fund on a regular basis. When doing this, it’s important to note that you’re reducing your capital base that is providing the growth. This means that using this strategy should allow you to maintain the value you hold in funds, but will likely not result in growth.
Should I Pick Index Funds Based on Dividends?
Whether you should pick an index fund based on dividends depends heavily on your goals.
In general, if you’re looking to passively build wealth for the long-term, dividends don’t matter. Instead, you should consider the overall growth of the fund (dividends and price growth). However, if you’re looking to use index funds to build passive income and cashflow, dividends may be a factor in the index fund you choose.
Taxation can also be a consideration in your decision, as dividends and capital gains may be taxed differently.
Picking Funds Based on Your Goals
If you are looking to increase your wealth and you’re not looking to withdraw the money any time soon, dividends should have no impact on your decision. Instead, you should be considering to overall return of the fund (both dividends and increase in fund value).
For example, the S&P 500 has had an average return of ~10%. Of that, only ~1.5% is the dividend (e.g. see ZSP.TO). If you were looking purely at dividend, this may not look that attractive, as this means that for every $10,000 invested, you’d get $150 in dividends annually. But if you’re going to re-invest the dividend anyways for long-term growth, the 10% is the figure you should focus on.
If you are looking to build passive income, and want to have income coming out of your investment regularly, choosing a fund based on dividends may make sense. In this circumstance, having a regular distribution (dividend) that puts money in your account may be attractive. And because you’re looking to use that money rather than re-investing, the overall yield of the investment may be less of a concern.
Taxation of Dividends vs. Capital Gains
The other consideration when deciding on if you want dividend income is how it’s treated with regards to taxation.
Taxation is treated differently depending if you’re in the United States or in Canada. But bottom line, review the different tax treatments with a certified accountant as it may have an impact on your decision.
How Do Index Funds Compare to Other Sources of Passive Income?
Compared to other sources of passive income, index funds have both advantages and disadvantages. In general, creating passive income through index funds is very simple and easy compared to other sources of passive income, but it requires a much higher capital base.
For the purposes of this analysis, I’m going to compare index funds to a variety of other sources of passive income, including content creation (youtube, blogging, music, etc.), selling goods (online or in-store), real estate, and high-yield savings accounts.
Difficulty
When it comes to creating sources of passive income, the difficulty of the pursuit is an important consideration. Here’s a description of the difficulty of various sources of passive income:
| Passive Income Source | Difficulty |
| Index Funds | It is incredibly easy and simple to create passive income using index funds. The only effort required is some upfront research. Once the fund(s) are purchased, the passive income will come. |
| Content Creation | Once you’ve established a follower base, content creation can be very fun. But building the skills and follower base to have income from content creation can be very high effort. As well, depending on the type of content creation (e.g. youtube), the effort can active, requiring continuing work on the income stream. |
| Selling Goods | Similar to content creation, selling goods can take a lot of effort upfront to build the skills and products and build the marketing channels. As well, depending on your involvement in creating and selling the goods, it may be more active. |
| Real Estate | Real estate can be a competitive industry, and depending on how you go about it, can be very active. If you choose to do your own property management, or are pursuing more active strategies (e.g. flipping), it can require a lot of effort. |
| High Yield Savings Accounts | Using high-yield savings accounts is very simple and easy. You just choose the account, and deposit funds. |
Predictability
Predictability of income is an important consideration when it comes to sources of passive income.
| Passive Income Source | Predictability |
| Index Funds | Index funds typically provide a predictable dividend return, meaning you can have a good idea of the passive income. However, because index funds follow the financial markets, the value of the fund can fluctuate significantly. |
| Content Creation | Content creation often creates income from a variety of sources including ads, affiliate marketing, and direct sales. Depending on your set-up, its possible to have some predictability in income, but you can also have an event suddenly reduce your income significantly. As well, you will see fluctuation monthly or seasonally. |
| Selling Goods | Selling goods can be seasonal, and may require innovation to keep in the market. Sales can fluctuate significantly. |
| Real Estate | The monthly income and expenses for real estate can be pretty predictable, but you can also be hit with large unexpected repairs. |
| High Yield Savings Accounts | High-yield savings accounts are the most predictable option. The interest rate is defined, so you know the exact amount you’re going to receive. |
Return and Potential Growth
Another important consideration for passive income sources is the potential return, and growth that can be generated over time.
| Passive Income Source | Return and Potential Growth |
| Index Funds | Index fund returns will depend on the underlying index that it follows. For example, the S&P 500 has returned ~10% annually. However, this growth is not linear. So there may be years where the fund loses 20%+, or grows by 20%+. However, if you’re taking money out of your investment account for passive income, you’re capping your future growth potential. |
| Content Creation | The return and growth on content creation can be extremely high. For example, the highest-earning youtuber (Mr. Beast) is reportedly worth over $100 million dollars, all stemming from his youtube channel. That said, few reach the insane levels that are possible. But it is possible to make a lot of money from content creation. |
| Selling Goods | So long as you have good processes in place, selling goods can scale to huge levels and provide huge upside. |
| Real Estate | With real estate, you have the ability to get creative and can greatly increase your returns. As well, with real estate, you can make money through appreciation, cashflow, and mortgage paydown, meaning you’ve got three streams for wealth to increase. |
| High Yield Savings Accounts | High-yield savings accounts have no upside beyond the provided rate. They will always return the amount advertised. |
Upfront Capital Required
When considering passive income sources, the upfront capital may have a strong impact.
| Passive Income Source | Upfront Capital Required |
| Index Funds | Creating passive income from index funds requires significant upfront capital. Using the 4% rule, you can back-calculate the amount of money you want as passive income to get your required capital. So if you wanted to make $50,000 in passive income annually, dividing by 4%, you would need $1.25 million dollars. |
| Content Creation | Content creation can be done with little to no upfront cost. You may need a little bit of start-up capital to acquire things like recording equipment, web hosting, etc., but this can be done on a budget. |
| Selling Goods | The upfront capital depends on the route you take. If you’re creating and selling goods one at a time, you can likely do so relatively inexpensively. But if you’re looking to bulk purchase, you may require significant upfront capital. |
| Real Estate | In general, getting started with real estate investing requires high upfront capital. You often need a downpayment, there will be closing costs, and there can be upfront renovations necessary. However, there are ways to get created through joint ventures or other avenues that can reduce the cost. |
| High Yield Savings Accounts | High-yield savings accounts would require immense amounts of money to build significant passive income. To determine this amount, just like with index funds, you can divide your desired income by the savings account yield. |
Time to First Return
Lastly, it’s important to consider how long it will take to see a return.
| Passive Income Source | Time to First Return |
| Index Funds | Index funds will fluctuate in the value with the market, but depending on the fund chosen, you could receive a dividend in as little as a couple months. That said, depending on your initial capital, it may take a while for the returns to be significant. |
| Content Creation | Content creation can take a long time to make any money. It could be months before you see a penny, and years before it’s a significant income. But as mentioned above, the upside is much higher. |
| Selling Goods | Selling goods can have almost immediate return. But depending on the demand for the goods, the time for you to recoup your investment could be months or years. |
| Real Estate | Depending on the state of the property, you can start renting it immediately to get some income. However, similar to selling goods it could take some time to recoup initial closing and renovation costs. |
| High Yield Savings Accounts | High-yield savings accounts start accruing interest immediately, but the interest rate is usually low (2-5%). |
Overall, building passive income through index funds is a very easy and simple way to immediately get return, but it takes a lot of upfront capital. It also has very limited upside compared to the other passive income sources noted.
How Much Do I Need to Invest to Make $1000 a Month in Passive Income?
To determine the amount of capital you need to make $1,000 a month, we need to divide the annual income by the expected return. So annually, you’d need to make $12,000.
Using the 4% rule, you would need $300,000 ($12,000/0.04) in capital to get $1,000 per month in passive income from stocks. However, if you are able to find a higher-yield dividend stock that returns for example 6%, you would only need $200,000 (12,000/0.06). That said, it’s high risk to be so concentrated in one or few stocks.