Extra money! How I’m generating tax-free passive income in 2022

Edward Sheldon explains how he’s using dividend stocks to generate regular passive income within his Stocks and Shares ISA.

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Passive income – money generated without having to actively work for it – is often thought of as the ‘holy grail’ of personal finance. This form of income can provide a whole new level of financial freedom.

While generating extra money without working for it may sound impossible to many, it’s actually pretty easy to do these days. With that in mind, here’s a look at how I’m generating passive income (tax-free) in 2022.

Passive income from dividend stocks

There are many different ways to generate passive income today. However, my preferred method is investing in dividend stocks. These are stocks that pay out regular cash payments (dividends) to investors out of company profits. A dividend is essentially a payment for being a part-owner of the underlying business.

By investing in dividend stocks, I receive cash payments on a regular basis for doing absolutely nothing. So it’s passive income in its purest form. And the yield I earn is quite impressive (much better than the interest I’m getting from money in the bank). For example, I have stocks that currently yield around 7%. Meanwhile, because I buy them within a Stocks and Shares ISA, these cash payments are tax-free.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

Examples

One example of a dividend stock that provides me with regular passive income is Unilever, the consumer goods giant that owns a wide range of well-known brands.

Unilever is a reliable dividend payer, having rewarded investors with a cash payout every year for more than two decades. It also has a good track when it comes to increasing its distributions, meaning my income from the stock has risen over time.

Currently, Unilever offers a yield of around 3.7%. So if I was to invest £1,000 in the company today, I’d pick up passive income of around £37 for the year. If I was to invest £5,000, I’d receive dividends of around £185 per year.

Another dividend stock I own is leading insurance and investment company Legal & General. The group has put together a great dividend growth track record over the last decade, raising its payout substantially. As a result, it offers a very attractive yield of around 7%. So if I was to invest £1,000 in the stock now, I’d receive roughly £70 in dividends per year. Invest £5,000, and I’d pick up about £350.

Money for nothing

Using these examples, it’s easy to see how to build up a nice stream of passive income with dividend stocks. If I was to own 20 stocks with £2,500 invested in each, and the average yield across my portfolio was 4%, I’d pick up dividends of approximately £2,000 per year.

Not bad for doing absolutely nothing.

Risks

So what’s the catch? Well, there are a couple. The first is that, unlike bank interest, dividends aren’t guaranteed. Companies can cancel or reduce them at any time.

The second is that, while the share prices of good companies tend to rise over the long term, they can rise and fall in the short term. So I could lose money with this strategy.

However, I’m comfortable with these risks. I’m a long-term investor, so when I buy a stock for passive income, I plan to hold it for five years, or more. This reduces the chance of losing money from share price fluctuations.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Edward Sheldon has positions in Legal & General Group and Unilever. The Motley Fool UK has recommended 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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