£10,000 in savings? I’d aim for a £21,859-a-year second income

With thousands stashed away, here’s how this Fool would start making a second income through buying dividend shares.

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Over the past few years, plenty of investors have become more conscious of building a second income.

It makes sense. With inflation eating away at our pockets, I want to make sure that my money is working as hard as possible for me. I keep some stashed away for a rainy day. But instead of letting my money sit idle in the bank, I invest it in the stock market.

To build my second income, I’ve been buying dividend shares. In my view, it’s one of the simplest forms of passive income.

Let’s say I had £10,000 saved and ready to invest. Here’s how I’d start generating some extra cash.

Investment vehicle

First, I’d invest through a vehicle like a Stocks and Shares ISA. Every investor has a £20,000 limit each year. What’s good about an ISA is that all the profit I make is tax-free. Over the course of years and decades, this makes a massive difference.

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.

Where to invest

So, I’m going to use an ISA to maximise my gains. But what do I buy? Well, I’d largely opt for FTSE 100 shares.

The index is home to a host of businesses that have bulky yields. The average yield is 3.6%. For comparison, the American S&P 500’s is just 1.4%.

Footsie firms are household names with proven business models and generally stable cash flows. That means they’re often in a strong position to keep rewarding shareholders.

But I also own some FTSE 250 stocks for passive income. For example, I recently added to my position in stalwart broadcaster ITV. While some companies on the index are less well-known than their Footsie counterparts, it’s still a great place to go shopping for under-the-radar buys.

This in action

That said, I largely stick to the FTSE 100. One stock I own that pays me a handsome income is British American Tobacco (LSE: BATS). It yields a whopping 9.7%. What’s more, its shares look dirt cheap, trading on just 6.4 times earnings. That’s below the Footsie average of 11.

The business also has an amazing track record of paying out. It has rewarded shareholders with a dividend for over two decades. That means even during events such as the Global Financial Crash and the pandemic it has still paid up. Dividends are never guaranteed, so that’s mighty impressive.

The firm expects to generate £40bn in free cash flow in the next five years. Coupled with that, analysts predict its earnings will grow at a rate just shy of 50% every year to the end of 2026.

That’s not to say it doesn’t face challenges. Smoking is a habit that’s increasingly frowned upon. Governments are clamping down on the industry with increasing regulation.

However, the firm is overcoming this by investing more in its New Categories division. In 2023, revenue for these products rose by 21%.

Hitting my targets

But how could I turn £10,000 into a second income? Taking British American Tobacco’s 9.7% yield and applying it to my £10,000 would see me earn £970 a year in passive income.

However, there are ways I could boost this. For example, if I reinvested my dividends and invested a further £100 a month, after 25 years, I’d potentially earn £21,859 in interest.

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. and ITV. The Motley Fool UK has recommended British American Tobacco P.l.c. and ITV. 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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