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How to make passive income from dividends in 2021

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Setting up a passive income stream with whatever savings one has could be a very wise way to begin 2021. With the Covid-19 continuing to hold businesses back and unemployment levels likely to rise, having a second source of cash coming in never made more sense.

Here’s how I’d get started.

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Passive income 101

The first thing to sort before buying anything whatsoever is to open up a Stocks and Shares ISA. By doing so, I know that any dividends I receive won’t be taxed. That might mean saving only a few pence in the beginning, but it could amount to an awful lot of pounds as the years pass.

As an aside, sheltering my investments in an ISA will also protect me from paying capital gains tax further down the line when I come to sell. Again, why would anyone want to hand back money to the government if they can legally avoid doing so?

Buy the best

Once an investor has an ISA ready to go, it’s time to buy some shares. Rather than dive in indiscriminately however, I’d look for the best of the best. 

The first thing I’d check for is whether a firm is actually paying dividends. Unfortunately, a lot of previously great dividend stocks are not currently giving anything back due to the coronavirus. This may be because they’d rather not or, more worryingly, because they simply can’t. 

Assuming a company is still providing holders with a passive income stream however, the next thing to check is whether the dividends are sustainable. The key thing to look at here is the dividend yield.

As a rough rule of thumb, a yield greater than 6% usually requires further investigation. It suggests the market suspects this cash may not be returned. Since a yield can look massive when a share price has fallen heavily, it’s vital to check how a company is faring before buying its shares.  

Another ratio to look at is the dividend cover. This is the extent to which dividends are covered by profits. A cover of two is ideal here. Anything less than one is best avoided. It means a company is tapping into its reserves to pay shareholders.

A final thing to note is whether dividends have been/are increasing. A regularly-hiked payout suggests a business is growing and management is confident about the future. Stagnant dividends can point to a company treading water.

Plan B

If picking individual stocks feels too risky, there’s another way of generating passive income. This involves buying what’s known as an exchange-traded fund. These cheap funds simply track a basket of shares rather than a single company. The iShares Core FTSE 100 UCITS ETF, for example, generates the same return as the FTSE 100 index. 

Most importantly, buying a product like the one above pays dividends. At the time of writing, the iShares ETF yields a very respectable 3.1%. That’s a lot more than I’d get from a Cash ISA!

One last thing

Although spending any dividends I receive from shares is tempting, I’m also aware that reinvesting this cash will make me considerably richer in time thanks to the brilliance of compound interest. 

While generating a second income in 2021 is wise, throwing whatever I receive back into the market is an even better plan.

Receive, reinvest, repeat. That’s the Foolish way.

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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.