Here’s how I’d turn £10,000 of savings into £19,794 a year of passive income

This Fool plans to start generating passive income for his retirement today. With a £10,000 lump sum, here’s how he’d go about it.

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Making passive income is more important than ever. Inflation has squeezed our wallets. As such, I want to make sure that I’m putting my money to work in the most effective way possible.

There are a few routes I could take. But I’m starting out by buying dividend shares. It’s one of the simplest ways to make some extra cash outside my main source of income.

As Warren Buffett once said: “If you don’t find a way to make money while you sleep, you will work until you die.” I want to invest today so that I can have a better lifestyle further down the line.

If I had a spare £10,000 in cash, I’d put it in the stock market. Here’s how I’d go about it.

Making my money work for me

As I’ve highlighted above, the key is making my money work for me. That’s why I’d invest through a Stocks and Shares ISA. It’s a tax wrapper. Any capital gains or dividends I receive through my ISA, I pay zero tax on. Every UK investor has a £20,000 annual contribution limit. That means even after my £10,000 lump sum, I still have a good amount of my allowance left.

As such, I’d bolster my initial savings with monthly contributions. Right now, I’m in a position to invest around £200 a month. As time goes on, I’ll look to increase this.

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.

Targeting the best

But how do I plan to generate passive income? The answer is through owning stocks such as British American Tobacco (LSE: BATS).

As I write, it yields a whopping 9.7%. That’s the second-highest on the Footsie. However, what’s more appealing for me is its status as a Dividend Aristocrat. It has upped its annual payout for nearly a quarter of a century. Given some of the challenges the business has faced during that time, including most recently the pandemic, that’s seriously impressive.

As well as that, the stock looks undervalued. It now trades on just six times trailing earnings. That said, I’m in for the long haul. I don’t want to invest in a company today only for its share price to decline in the decades ahead. With British American Tobacco, this is of course a risk given the falling popularity and heightened scrutiny being placed on smoking.

However, I’m not too worried about that. It’s combatting this by diversifying its revenue streams into non-combustible goods, which it’s making solid progress with.

How much could I make?

So, I’ve selected what sort of companies I plan to own. How much could I make?

That depends on the investing timeframe. For me, it’s 30 years. So, let’s go with that.

After that time, assuming a 9.7% return each year, my initial £10,000, plus my £200 monthly contributions, could be worth £494,847. If I were then to apply the 4% ‘drawdown’ rule, that would leave me with £19,794 a year in passive income.

The stock market is volatile and dividends are never guaranteed. While I’d aim for a 9.7% return, there’s always the risk I don’t achieve it. What’s more, I’d diversify my portfolio.

But by remaining consistent and investing for the long run, I’m confident that I can build passive income streams that will help me retire early.

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.

Charlie Keough has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended British American Tobacco P.l.c. 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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