The secret to financial independence is when your passive income takes that step

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April is Financial Literacy Month

The National Financial Educators Council (NFEC) defines financial literacy as “the possession of the skills and knowledge about financial matters to confidently take effective action that best meets an individual’s personal, family, and global community goals” .

keywords? “Take effective action”.

This week I want to talk about the very foundation and foundation of financial planning, the pillars on which it is all built, namely your income and your expenses. How are they connected? How do they fit into an overall financial plan? How and what action should you take?

We start with your income.

There are two types of income – Active income and passive income. Active income is the income you earn by being physically present at work (it doesn’t have to be geographical). This includes salaries as an employee and the owner’s drawings as an owner. Passive income is any income you earn when you are not physically present or through property. This includes rents, dividends, and even your share as a silent partner in a business.

How are your active and passive income connected?

If you are employed, you earn a salary; even as a business owner, you get paid for showing up. The active income you earn is time-limited because you cannot work indefinitely. So the plan is to slowly convert your active income into passive income. Created a closed system when you invest, then reinvest the earnings in your portfolio to accumulate your returns. See figure 1.

An example will be that you earn N500,000 per month. You have a plan to save at least 10% of each paycheck, so N50,000. Therefore, your action objective is to invest N50,000 in an asset class that is…

  1. Generates passive income for you
  2. Reduces your level of spending

So, if you buy Zenith shares with these N50,000, you want to collect the dividends paid by Zenith Bank and buy more income-generating or expense-generating assets that reduce future expenses such as paying rent.

Goal: Plan to convert 100% of active income to passive income over a period. Keep it simple, target 1%, then 2%… then 3% beyond

Figure 1. Relationship between income and expenditure

Now Expenses

Just like income, there are two types of expenses. You have your non-discretionary expenses, which are expenses you have to make regardless of your income or even your ability to pay, for example, food and rent. We can call these expenses necessary. Then there are discretionary expenses, which are expenses that you are free to incur. Expenses like a vacation to Greece or a new suit fall into this category.

With spending, spending becomes critical. Spending is an emotion-based activity. Humans aren’t always rational when making spending decisions. Remember that each naira earmarked as non-discretionary means fewer funds are available to spend on a discretionary basis. If all expenses are labeled as “essential”, budgeting becomes a tedious process.

How are your non-discretionary and discretionary spending related?

Your total income (both active and passive) should meet and exceed expenses. If your expenses exceed your income, you can either reduce your expenses or learn a skill and increase your income. Spending reduction is 100% under your control. It is also not easy to distinguish between non-discretionary spending and discretionary spending. Taking food, isn’t dining out discretionary? You can save money by eating at home.

The long-term goal is to ensure not only that your income meets expenses, but the litmus test is how much your passive income can offset your non-discretionary expenses. See Figure 2

Expense management involves creating and using a budget to capture and track expenses. Your budget should contain all four elements

  1. Active income
  2. Passive income
  3. Non-discretionary income
  4. Discretionary income

I write about this in more detail in my book “Let’s talk about your money”

There is a gap between income and expenditure, which is usually covered by debt. It is important not to borrow to fund non-discretionary spending, but to use debt to develop passive income-generating sources.

When can you retire?

Retirement is not a chronological date but the period during which your passive income can meet and cover your non-discretionary expenses. Again, we refer to Scheme 2.

Figure 2: Financial independence

Your goal, employee or employer, is to first earn income, then slowly invest that income to earn and grow your passive income. Next, look to pay for your essential non-discretionary expenses with income from your passive income. Once you can achieve this, you have achieved your goal of financial independence and can retire.

It’s so simple.

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