Here’s how I’d invest £20k in high-yield dividend shares to target £500 in monthly passive income

With £20,000 in savings and bit of research, our writer thinks it’s perfectly possibly to generate a tidy passive income stream over the long term.

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I don’t have the time, energy or brain power to run a second business or invent something everyone wants. So, I think the stock market is my best option for generating passive income.

Here’s what I’d do with £20,000 at my disposal.

Getting organised

My first step would be to chuck the entire amount into a Stocks and Shares ISA. Conveniently, this amount is currently the maximum I can deposit into this kind of account per year.

But the main reason for housing my investments inside an ISA is that I won’t pay tax on any income I receive. I’ll come back to this in a bit.

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.

Buyer beware

I now need to think about which high-yield dividend stocks might be worth buying.

Spoiler alert: not all companies that return lots of cash to their owners are great buys!

At least some offer high yields because their share prices have tanked, perhaps because trading is bad. When this happens, the yield rises.

If things don’t improve, there’s a chance that dividends will be cut or cancelled completely to preserve cash.

There are exceptions

Not every high-yielding stock is necessarily a disaster in waiting.

Housebuilder Taylor Wimpey (LSE: TW.) is one I’m more comfortable about. As thing stand, analysts have the company down to return 9.31p per share in FY24. Using the current share price, that gives a dividend yield of 6.4%, making it one of the biggest payers in the entire FTSE 100.

Is this all nailed on? Sadly, no. A fresh economic headwind could see another dip in demand for housing. This would impact the Taylor’s bottom line and possibly its ability to pay dividends.

But I’m optimistic about this UK titan.

Firstly, its balance sheet is already in great shape.

Secondly, a cut to interest rates later this summer could be the catalyst for the next housing boom.

Third, there remains a huge shortage of quality housing in the UK. As a big player, this is surely positive for the company’s long-term outlook.

Safety in numbers

So, would I invest my full £20k in Taylor Wimpey? Absolutely not! Going ‘all in’ on any stock is asking for trouble, regardless of its quality.

Instead, I’d spread my cash around other shares to reduce risk. This is known as diversification and it might just save me from a world of (financial) pain.

To be clear, being diversified won’t stop my portfolio from losing value during a market correction or crash.

However, it should mean that my income stream isn’t massively disrupted if one or two stocks have to cancel their payouts.

Small steps

Investing in 10 or so companies for an average yield of 6.4% would only generate £1,280 per year in dividends. That’s nowhere near the £500 per month I’m looking for.

But this is where the secret investing sauce that is compounding comes in. By reinvesting the passive income I receive over time, I’m more likely to get to where I want to be.

Compounding at 6.4% annually for 25 years will generate just over £500 per month. I think that’s very achievable, especially if I’m shielding all of my gains from the taxman (remember him?).

And the more money I can add on top of that initial £20k, the greater that passive income pile might become!

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.

Paul Summers 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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