There are multiple ways to earn passive income, but one of my favoured methods is by owning dividend shares.
Buy-to-let property investing was a popular way to earn a second income, but higher home prices combined with a less favourable tax system has made it less desirable, in my opinion.
By contrast, a Stocks and Shares ISA can offer a tax-free solution to invest smaller sums.
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.
Targeting passive income
Currently, with a £20k annual cap on an ISA, it would take a few years to fully invest my £60k.
But then the fun begins with dividends. To earn £4,800 a year in annual passive income, I’d need to achieve an 8% return.
With an average FTSE 100 dividend yield of 3.7%, I’d need to shoot for more than double that. Although it might sound like a tricky challenge, I can see several Footsie shares that match my target.
Sharing profits
But a word of warning. There’s more to dividend shares than just its yield. As payouts aren’t guaranteed, they can be cut or suspended at any time.
Dividends are typically paid from earnings, so if a company’s profits are expected to take a hit, management might decide to cut back on its payments to shareholders. Dividends are essentially a share of business profits.
That’s why I’d focus on shares that offer stable and steadily growing earnings. I prefer established names with a long history of paying consistent dividends.
Billionaire investor Warren Buffett often refers to his liking of moats, as do I. These are competitive advantages that allows a business to operate with a high and stable profit margin.
How I’d fill my buckets
With £60,000 to allocate towards this income strategy, here’s what I’d do. First, I’d split my total pot into several smaller buckets.
For instance, as I’m sticking to a selection of large and mature companies from the FTSE 100, I’d split my pot 10 ways. By investing £6k in each of my top 10 shares, I’d benefit from diversification.
If something were to go wrong with one company, owning a mix of other shares should protect me from significant losses.
Ideally, I’d also try to own shares that operate in different industries to each other. That would avoid me putting all my eggs in one basket.
Top shares
I’ve done some homework and found a selection of income shares that meet my criteria. If I had spare cash to devote to this strategy, I’d buy the following 10 dividend stocks: Glencore, Phoenix Group, Legal & General, Vodafone, Rio Tinto, B&M, Imperial Tobacco, Barratt Developments, abrdn, and HSBC.
I calculate that should be sufficient enough to earn an 8% dividend yield and £4,800 a year in passive income.
Despite picking established companies, bear in mind that the business environment can change. So I’d need to keep an eye on my share selection to avoid owning duds.
