How I’d generate £5,000 a year in passive income from dividend stocks

Investing in dividend stocks is an easy way to generate passive income. Here, Ed Sheldon explains how he’d aim to generate £5k a year from dividend shares.

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Investing in dividend stocks can be a great way to generate passive income. These stocks pay investors regular cash payments for doing absolutely nothing.

Here, I’m going to explain how I’d build a portfolio of UK dividend stocks that’s potentially capable of generating £5,000 per year in passive income for me. These are the steps I’d take to build a rock-solid, income-generating portfolio.

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Finding the best dividend stocks for passive income

The first thing I’d do, if my goal was to generate £5k of passive income per year from dividend stocks, is screen the UK market for stocks with attractive yields. I’d do this with a stock screening tool.

When I say ‘attractive’, I’m referring to yields that are higher than 2% but lower than 6.5%. The reason I’d cap my yield at 6.5% is that a super-high yield is often a sign that the company is in financial distress and that its dividend payout isn’t sustainable. What’s happened is that the ‘smart money’ has already dumped the stock, pushing its share price down and its yield up.

Reliable dividend payers

Once I had a list of dividend stocks at hand, I’d then pick out the most reliable dividend payers. I’d do this by looking at companies’ dividend track records. Businesses can cut, suspend, and cancel their dividends at any time so I’d want to find those that I can depend on for passive income. 

It’s worth pointing out here that there are a number of companies in the UK that have exceptional long-term dividend track records. Unilever, Diageo, Sage, and Smith & Nephew are some good examples.

Dividend growth potential

With my list of reliable dividend payers, I’d then look for companies with long-term growth prospects that have the potential to raise their dividend payouts over time. Rising dividends would help me offset inflation.

Attractive valuations

Finally, I’d look for companies that trade at reasonable valuations. I wouldn’t want to pay an excessive valuation for a company as this could potentially result in share price losses.

One example of a dividend stock that I think trades at an attractive valuation at present is Unilever. It currently sports a forward-looking price-to-earnings (P/E) ratio of about 16.7. This is not high, in my view, given the company’s track record and long-term growth potential.

Building a passive income portfolio

Once I had a list of top dividend stocks, I’d then put together a portfolio of around 20 companies. I’d pick stocks from a number of different sectors including consumer staples, healthcare, and technology in order to ensure that the portfolio is well diversified.

In terms of yield, I’d aim to pick up an average portfolio yield of around 4%. I think that’s very achievable in today’s market. With a 4% yield, I would need to invest a total of £125,000 to generate £5,000 in passive income.

Tax-free income

I’ll point out that I’d try to invest as much as possible in tax-efficient accounts in order to pay as little tax as possible on my passive income. A Stocks and Shares ISA is a good example of a tax-efficient account. With this kind of investment account, all capital gains and income are sheltered from the taxman.

If I was able to generate £5k in passive income in an ISA, it would be entirely tax-free.

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Edward Sheldon owns Diageo, Sage Group, Smith & Nephew, and Unilever. The Motley Fool UK has recommended Diageo, Sage Group, Smith & Nephew, and Unilever. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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