Popular ways to earn passive income include buying a property to let and starting an online business. However, these ventures normally involve a large amount of upfront capital or time to get off the ground.
In contrast, anyone can start investing in dividend-paying shares, even a 40-year-old starting from scratch with no savings.
Here, I’ll show how an insignificant-sounding £10 a day can eventually grow into a sizeable tax-free passive income stream.
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.
Making sacrifices
In recent years, the UK has become a much tougher place to live affordably and save money. We can see this cost-of-living crisis all around us, from derelict shops to half-empty restaurants and pubs.
What were once affordable treats are becoming incredibly expensive. For example, some Premier League clubs are tipped to be charging fans upwards of £13 for a pint of beer by 2030! A few cafes are already charging more than £5 for a single cup of coffee, while the price of fish and chips is through the roof.
Still, I firmly believe that a determined individual can save an extra tenner a day and start putting it to work in the stock market. That equals roughly £304 a month or £3,650 per year.
An illustration
The good news is that this figure is well inside the annual £20k Stocks and Shares ISA allowance. This means any income generated in this account would be free from the grubby mitts of the taxman!
Say a person invests their money at an average dividend yield of 6%. In other words, they ought to receive £6 per year back in dividends for every £100 they invest. This scenario would see regular £304 monthly investments turn into £137,000 in just under 20 years. And annual dividends of £8,273!
| Year | Balance |
|---|---|
| 1 | £3,748.32 |
| 5 | £21,129.63 |
| 10 | £49,405.84 |
| 15 | £87,245.78 |
| 20 | £137,884.17 |
Now, there are a few caveats here. First, a company’s dividend should trend upwards over time as its profits grow. This means an income portfolio’s yield should ideally be higher than 6% after two decades.
However, this isn’t assured because companies can run into trouble and cut their payouts. Therefore, diversification is an important tool to offset this risk.
Also, the above figures assume an investor reinvests dividends to really turbocharge compounding (earning interest upon interest). This would mean sacrificing the spending of cash dividends for the chance of a much higher passive income stream in future.
What stocks to consider?
One of my favourite UK income stocks is Legal & General (LSE: LGEN). This FTSE 100 financial services giant currently sports an enormous 9.7% forecast dividend yield for FY25.
The company boasts a strong brand in enduring industries like asset management, insurance, and pension products. All are poised for steady long-term growth due to a rapidly ageing population.
Meanwhile, Legal & General maintains a solid balance sheet, ensuring it can weather market shocks.
Admittedly, the share price performance — down 27% in five years — has been disappointing. A financial crisis of some sort could heap pressure on earnings, given the firm manages £1.2trn worth of assets.
However, the company has hinted that the board may increase the current £200m share buyback. That could support a rising share price, ideally.
On balance, I think the stock’s cheap valuation and sky-high dividend yield look attractive. I’m considering buying more shares in the coming weeks.
