I believe that the ultimate form of passive income comes from dividend stocks. This is because there isn’t anything an investor needs to do in terms of managing the company.
By making use of a Stocks and Shares ISA, investors can do this in a tax-efficient manner. This is a type of individual savings account where you can invest in shares without paying any capital gains tax on gains realised, or dividend tax on income received. You can invest up to £20,000 a year into this account.
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.
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A passive income plan
Now that I’ve established a tax-efficient way to invest in shares, how does an investor create passive income from them?
As mentioned above, they’ll want to do this by considering investing in dividend shares with high yields. The FTSE 100 has a dividend yield of 3.7%. However, I’ll assume that the portfolio will earn a higher amount of 5%, as it will be focused on high-yielding stocks.
It’s important to understand that dividends aren’t guaranteed, but if an investor wanted an additional £2,000 second income from this dividend portfolio, they would need £480,000.
The problem is that this is a lot of money to have on hand.
However, investors may consider using £20,000 of cash to max out their ISAs before the tax year ends. From there on, they could aim to invest £830 a month, which is about £10k a year (half of the ISA allowance). Assuming dividends are reinvested and that annual dividend and share price growth are only a modest 1.5%, they should have £480,000 in 20 years.
Crucially, the stock portfolio should be paying annual dividends of £25,086 from this point onwards. This represents £2,091 in monthly passive income.
I appreciate that £20k in savings is still quite a lot of spare money to have on hand. Furthermore, setting aside a further £830 a month isn’t easy. But it’s still interesting to note how you could get that £2k a month.
Legal & General
Legal & General (LSE:LGEN) shares are a great example of what could be considered for this portfolio.
The company currently sports a dividend yield of 9%. This is above the 5% target in our portfolio above. While our portfolio should be diversified, the company’s shares will help to bring the average yield up.
Since the start of 2024, its shares have declined by 8.4%, which isn’t great considering that the Footsie has risen by 6.4% over the same period.
However, income investors will understand that this means the cost to obtain the future stream of the company’s dividends is now 8.4% cheaper than it was before.
Furthermore, the board has announced its intention to grow the dividend by 2% annually until 2027. This should also pull the average dividend growth up of our hypothetical portfolio, in which I only accounted for a 1.5% annual rise.
As an insurance firm, its performance is usually tied to that of the economy. Therefore, its shares may struggle while there’s pessimism around the UK economy.
Though, I think the company is still a safe bet in the long run and investors should consider adding some of its shares to their portfolio.
