How to Fund Your Retirement With Passive Income

By Joe Udo | U.S.News & World Report LP – Fri, Aug 15, 2014

Here is the standard formula for retirement saving. Many financial planners recommend that you save 10 percent to 15 percent of you income for retirement as soon as you start your first full-time job. Save for 40 to 50 years, and you'll probably have enough retirement savings to replace 80 percent of your income. After retirement, you can withdraw about 4 percent from your retirement fund every year. This will draw down your nest egg, and hopefully it'll last long enough until you don't need it anymore.

Here are the rules of thumb for retirement saving.

-- Save 10 percent to 15 percent starting in your early 20s.

-- Save until you can replace 80 percent of your preretirement income.

-- Draw down 4 percent annually.

Of course, that's just the general guideline, and you need to plan your own retirement. There are a few problems with the rules of thumb. First, many people can't save 10 percent to 15 percent of their income in their 40s, let alone in their 20s. Second, 80 percent of your preretirement income is actually a huge amount, maybe much more than you initially thought. Finally, you might outlive your retirement portfolio if you retire at the wrong time. If you retired in 2008 when the stock market dropped nearly 35 percent, then you started your retirement years in a big hole. Withdrawing 4 percent in 2008 would have decreased your retirement portfolio and reduced the future earnings by a large amount.

An alternative to the established retirement planning model is to fund your retirement with passive income. Instead of focusing on saving a huge amount, you can focus on generating income outside your day job. It will take a lot of time and effort, but hopefully the passive income will be able to cover your monthly expenses at some point.

Here are some sources of passive income:

Rental properties. Many investors have been able to retire from their full-time jobs with rental income. It can be difficult to get started because you'll need a substantial amount of money for a down payment. One way to start in the rental property business is to rent out your old home when you move. You're familiar with the home and can probably manage it yourself.

Dividend stocks. Many companies in the stock market will send their investors a regular dividend payment. For example, AT&T will pay $1.84 dividend for every share. The good thing about investing in dividend stocks is that you can start small. If you have $1,000 to invest, you can buy AT&T and receive a steady 5 percent dividend every year. Fifty dollars might not sound like much, but the dividend income will increase as you add more to your dividend portfolio.

Business income. Another way to generate passive income is to build a business and hire employees to run it. This is very difficult because it's hard to be passive about a business you own. Employees will need supervision, and many businesses will go downhill if you don't pay attention.

Bonds. Investors can also lend money to the government and other private corporations. Currently, interest rates are very low, so the rates of return on bonds are also quite low.

Certificate of deposit. You can also lend money to your bank or credit union for a fixed term (three months, six months or one to five years.) CDs are very safe because many banks are insured by the Federal Deposit Insurance Corp. The return is also currently very low due to interest rates.

Peer-to-peer lending. A relative new way to generate passive income is to lend your money directly to borrowers via peer-to-peer lending companies like Prosper and Lending Club. The investor acts like a bank in this case. The interest rate is much higher than CDs and bonds, but the default risk is also much higher when you lend directly to borrowers.

These are just a few common ways to generate passive income, and you're only limited by your imagination. You can create products like a piece of art, music or a book to receive residual income. You can also sell some of your old stuff on eBay and create a storefront if that works well. You can even rent out a spare room if you don't mind having a roommate.

The good thing about retirement with passive income is that you have more control. You control your monthly expenses, and you can reduce those to accomplish your goal faster. You can try different ways to generate passive income and stick with what you're good at. Some people are really good at rental properties, and some people are more comfortable with dividend stocks. The best part about passive income is that you don't need to draw down your nest egg, so it has a better chance of lasting the rest of your life.

Of course, there are some negatives. It's generally difficult to generate enough passive income to cover your cost of living because the rate of return is not very high. Generally, you will need to save much more than 10 percent to 15 percent to generate substantial passive income. Passive income can also decrease over time if you don't pay attention to it.

Retiring by passive income is an alternative model that might work for some people better than others. If you are willing to explore different possibilities and enjoy managing your passive income streams, you'll probably like this model more than following the usual rules of thumb.

Joe Udo blogs at Retire By 40 where he writes about passive income, frugal living, retirement investing and the challenges of early retirement. He recently left his corporate job to be a stay at home dad and blogger and is having the time of his life.