How to earn a lifelong second income from dividend stocks in 5 simple steps!

Dividend investors can earn a second income from the stock market for life. Here’s a five-step plan to consider following in pursuit of this goal.

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When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

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The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

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Working hard to earn money is important. However, it’s equally crucial for investors to make sure their money is working hard for them. With that in mind, investing in dividend shares can be an excellent way to generate a second income.

Here’s how I’d aim to secure lifelong passive income using five simple steps.

1. Save regularly

As the old saying goes, there’s no such thing as a free lunch. Investing requires capital.

Even seasoned stock market veterans started somewhere. Warren Buffett famously made his first share purchases aged 11 for a grand total of $114.

Some things remain true 82 years later. Dividend investing still has low barriers to entry compared to many other forms of passive income generation, such as buy-to-let properties.

By developing good savings habits and squirreling away even small sums of money into a well-considered portfolio, investors can hope to reap long-term rewards.

2. Use an ISA

Few people want to pay more tax than they should. In that context, it’s important to note that the UK’s tax-free dividend allowance has been slashed to a measly £500 per year.

Fortunately, there are ways for investors to limit any bills due to HMRC and maximise their second income potential.

Using a Stocks and Shares ISA is one attractive option. There are plenty of different brokers to choose from and it’s worth researching the best fit in terms of fees and investment product offerings.

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.

3. Understand dividends

It’s also essential for investors to understand what dividends are and the potential risks involved.

Essentially, dividends are cash distributions paid by some companies to their shareholders from current earnings or accumulated profits.

They’re not guaranteed. Firms can amend their dividend policies to respond to challenging trading conditions. If a business enters financial difficulty, dividend payments can be cut, postponed, or scrapped altogether.

4. Find stocks to buy

There are several metrics to bear in mind when investing in dividend shares, including the firm’s yield, distribution history, and dividend coverage ratios.

For a concrete example of a dividend stock worth considering, IG Group (LSE:IGG) is a FTSE 250 company that looks attractive to me right now.

The online trading services provider performs well across key dividend indicators.

It boasts a handsome 5.6% yield, comfortably beating the average for FTSE 100 and FTSE 250 shares. What’s more, it’s maintained or increased payouts every year over the last decade and current cover is 2.1 times earnings, indicating a good margin of safety.

Given the group’s reliance on contract for difference (CFD) trading, it’s particularly exposed to volatility in financial markets. Plus, there are clear competition risks since numerous firms offer similar services.

That said, I think these risks are compensated by today’s valuation. The relatively low price-to-earnings (P/E) ratio around 11 could bode well for future returns. Recent share buybacks suggest the board shares this view.

5. Earn a second income

If all goes to plan, by investing in a diversified mix of quality dividend stocks, investors will start to earn a steady flow of passive income.

To boost the effect of compound returns on their portfolios, investors could elect to reinvest dividends into more shares. That’s what I’m doing until I need the extra cash closer to retirement.

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 Carman has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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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