Passive income is a great way to supplement earnings. One key difference to salaried earnings is that it involves little to no work once it’s set up.
One of my favourite methods to achieve this is by buying dividend shares. These investments distribute part of a company’s earnings to shareholders.
Why dividend shares?
There are several benefits to owning dividend stocks, in my opinion. In addition to receiving regular passive income, the value of my shares will likely rise over time.
The best dividend-paying shares also grow their payments. This can protect against rising inflation, particularly if payments rise more than general prices.
Finally, they tend to be mature and established businesses. One advantage of investing in these is that their share prices are often less volatile.
Calculating passive income
How much income could I earn? Well, that depends on a stocks’ dividend yield. Right now, the FTSE 100 offers a yield of around 3.8%.
In the current climate, that doesn’t sound that great to me. But within this large-cap index, I can see several high-yielding dividend shares that offer much more. Some stocks offer as much as 9% a year.
That £3 a day mentioned in the headline adds up to around £1,095 a year. After a year of investing that’s enough to earn £99 in passive income.
It’s not enough to quit the day job, but it’s just a start. Over time, I’d add more cash to this plan. And, bit by bit, my dividend income should grow.
Reinvest like the best
If I don’t need this cashflow in the near term, there are great benefits to reinvesting it. Instead of taking this income and spending it, I could buy more shares. And, in turn, I’d receive more dividends.
By repeating this process over several years, I’d expect to significantly enlarge my total pot.
Dividend reinvestment combined with the magic of compounding is a powerful mix. And investing for a long time could allow me to reap much larger rewards in the future.
| Years | Total Pot | Passive income per year |
| 5 | £6,553 | £590 |
| 15 | £31,150 | £2,894 |
| 30 | £149,257 | £13,433 |
| 45 | £575,815 | £51,823 |
What to buy?
Investors could consider buying into a dividend fund. This would hold a selection of income shares. Although yields on these funds can be higher than FTSE 100 trackers, I’d pick and choose a selection of the very best dividend stocks instead.
That’s because I can find several high-quality, high-yielding Footsie shares I think could beat the funds.
For instance, one of my top picks right now is Legal & General. With spare cash to devote to a passive income plan, I’d buy this.
It offers a 9% yield, and 31 years of back-to-back payments. It’s also well-covered by earnings, which is a good sign of dividend affordability.
Bear in mind that as dividends are typically paid from earnings, I’d need to keep an eye on my chosen stocks. Payments can sometimes be cut, or suspended, by management. If the outlook changes, I might need to reinvest my investment in other businesses.
