£20,000 in savings? Here’s how I’d aim to turn it into an annual £10,000 passive income

FTSE 100 dividend shares show just how much passive income we could generate by investing regularly and continuing with it for the long term.

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To build up a passive income, I don’t think we need look any further than top UK dividend stocks.

Stocks on London’s FTSE 100 index always seem to be valued a lot lower than their US counterparts.

Today, the FTSE 100 has an average price-to-earnings (P/E) ratio of about 12. So it would take 12 years of earnings to pay for the average share on the index.

US stock prices

In the US, the S&P 500 P/E is more than 25. Twice as many years of earnings are needed to pay for a share.

Both indexes are home to major global companies. The UK has firms like Unilever, BP, Shell, AstraZeneca… and many more that are every bit as international as those listed in the US.

Why there’s such a country difference, I don’t know. But the weaker valuations of FTSE 100 shares mean one big thing to me.

The dividend yield of the S&P 500 is a bit less than 1.5%. But the good old Footsie is on a 3.8% yield. So we should be able to buy top passive income shares for less money here.

Why £20k?

I chose £20,000 as that’s the current ISA annual contribution limit. So I can think about what we might earn if we can use the whole lot, without worrying about tax.

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.

There are some FTSE 100 stocks on dividends of 10% and more. But I won’t pick one of those biggest few. I’ll use Legal & General (LSE: LGEN) and its 8% yield as my example.

How much do I need?

To earn £10,000 in passive income at that rate, I’d need a pot of £125,000. Let me check under the bed and see if I have that much there… no, just some slippers and the cat.

But if I could invest a full £20,000 ISA allowance in Legal & General shares, I could get there in 24 years. That’s just one year’s allowance, no more cash added, and I could have my £10,000 a year in passive income.

I’d need to reinvest my dividends in more shares though.

As an aside, someone who could put down £20,000 every year could get there in only a bit over five years.

Owning shares

I chose Legal & General not just because of its high dividends, but I also think it can teach some other stock market lessons.

Its share price can be volatile, and it faces a lot of financial risk when the economy is in trouble.

So it’s important for anyone buying shares to see the company itself, and not just see numbers on a chart or in a table.

I understand and like Legal & General’s business, but I expect some bad years along with the good.

Safety first

So, I have three key rules for investing for passive income.

One, only buy shares in companies I understand and truly like. Two, plan to hold for at least 10 years (ideally 20 or more). And three, diversify across companies in different sectors.

With those in mind, I think Legal & General is a good example of the kind of thing that can be possible. I think I might buy some.

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.

Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has recommended AstraZeneca Plc and Unilever Plc. 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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