Seeking to build up an investment pot that pays passive income, I’d combine two of my favourite things. One is the UK stock market, which has beaten other forms of investment for more than a century.
Those planning to invest for less than a decade would face more risk than I’d be happy with. But it needs time and patience to build a solid second income, so I don’t see that as too much of a hardship.
Tax protection
My other favourite thing is a Stocks and Shares ISA. With one of those, we can invest up to £20k each year and not pay any tax when we finally take money out.
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Long-term plan
Diversification‘s a key part of my strategy. So I look for dividend-paying stocks in multiple sectors. I like banking and insurance. But I’m sure glad I didn’t have all my money in the finance sector when the 2008 banking collapse hit us. Or when Covid led to the banks suspending their dividends.
I’ll use one of my own investments here to illustrate how I’d aim for top passive income. The approach is straightforward and applies just as well to a diverse portfolio of dividend stocks.
Lloyds Banking Group (LSE: LLOY) has two key things I look for. Forecasts show rising dividends in the coming years, and they’d be well covered by earnings.
Banking favourite
I want my dividends to at least keep pace with inflation. And I’d never rely on dividends where I didn’t see the cash coming in to pay them.
The Lloyds share price has risen in 2024, dropping this year’s expected dividend yield to 4.8%.
But forecasts show it up to about 6% by 2026. So let’s see how a 6% annual dividend, reinvested in more shares, could compound upwards over the long term.
A single £20k ISA allowance invested in Lloyds shares, with that annual return, could more than treble in 20 years, to £64,000, without ever putting more money in.
Alternatively, £5,000 every year for 20 years could grow to a whopping £190,000.
Lloyds faces uncertainty as interest rates fall and should cut into lending margins. And the finance sector still looks a bit shaky. So I expect short-term volatility. Individual investors need to decide if they’re happy with that.
Spread the cash
If I was starting again today, I’d go for investment trusts first. I bought some City of London Investment Trust shares. And that’s been paying dividends of around 4.5-5%.
It’s not the biggest yield. But it diversifies across Unilever, HSBC Holdings, Shell, Tesco… and more top UK stocks. And it’s raised its dividend for 58 years in a row.
I’d also consider Murray Income Trust (4.5% yield, raised for 51 straight years), and Merchants Trust (4.9%, 42 years).
I keep in mind that dividends are never guaranteed though. And that’s one more reason to diversify, even among investment trusts.
