There are many ways that individuals can target a large second income when they retire.
Here’s my three-point strategy that could turn a £30,000 lump sum investment today into an annual passive income of nearly £55k.
1. Use a SIPP
Firstly, it’s worth considering opening an investment account that reduces or eliminates wealth-reducing tax liabilities. This can save individuals thousands of pounds each year they can invest to make even greater compound returns.
In the UK, both the Individual Savings Account (ISA) and the Self-Invested Personal Pension (SIPP) serve this purpose. Users of these products don’t pay a penny in capital gains tax or dividend tax.
For someone looking to invest a big amount like £30k, they might want to think about parking that in a SIPP.* As well as providing big tax savings, these pension products give users extra money to invest thanks to tax relief.
Let’s say this investor is a basic-rate taxpayer. After depositing £30k, they’d receive a 20% government ‘top-up’ which would be paid into their account within 10 weeks.
So in effect, they’d have £36,000 to start growing their retirement pot.
* The annual SIPP allowance is £60,000 or a sum equivalent to annual earnings, whichever is lower.
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.
2. Balance risk and reward
Investing in exchange-traded assets is riskier than holding one’s money in cash. However, for many people, the pull of substantially higher rewards makes this extra risk a worthwhile endeavour.
Individuals can still effectively tailor the amount of risk they’re prepared to take on, too, according to how they fill and structure their portfolio.
A SIPP user can hold a certain proportion of their investment in cash if they choose. They can also purchase a diversified selection of shares and other assets to balance their exposure.
Trusts like the Xtrackers MSCI World Momentum ETF (LSE:XDEM) can be an effective way to achieve this. This particular exchange-traded fund (ETF) has holdings in approximately 360 companies across the world and spanning multiple sectors.
Major holdings range from Nvidia and Walmart, through to Berkshire Hathaway and JP Morgan Chase.
With a focus on momentum shares, it has the potential to deliver market-beating capital gains. However, a high weighting of US shares (approximately 76% of the ETF) also means it may carry more risk than a more globally diverse fund.
Encouragingly the fund has an excellent long-term track record, delivering an average annual return of 12% since early 2015. If this continues, a £36k investment today would — after 30 years — become a terrific £1,294,187.
3. Buy high-yield dividend shares
There are multiple ways that investors can then try and turn this into a passive income in retirement.
They could purchase an annuity with it. Alternatively, they could draw down 4% of it a year, which would provide a second income for around three decades.
Another option to consider would be to purchase high-yielding dividend stocks. For example, investing that £1m portfolio in high-yield dividend stocks with an average yield of 5% could generate an annual passive income of approximately £64,709.
And with this method, an investor gives their portfolio further scope to grow over time.
