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How I’d aim to earn a rising passive income from dividend stocks

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One of the best things about FTSE 100 shares is that they can help investors to generate a rising passive income for retirement.

During the wealth-building phase, I would reinvest my dividends for growth. After I stopped working, I would draw them as income. Given that most companies aim to increase their dividends every year, that income should rise over time. I would then use it to top up other sources of retirement income, such as my State Pension and workplace one.

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That income may be ‘passive’, but it should allow me to enjoy an active retirement, by generating income to spend on the activities I enjoy.

I’d buy FTSE dividend stocks for my retirement

Dividend income is not guaranteed, of course. As we saw last year, companies are free to scrap or suspend their payouts at any time. That is why I would invest in a spread of stocks, to reduce the risk to my income stream from one or two doing this.

Investing in top FTSE 100 dividend stocks is particularly attractive right now, when the average savings account pays 0.06%. It is possible to generate a passive income of 5% a year, and more than 7% on one or two companies. That is quite incredible, when I consider the alternatives.

I don’t just look at the headline yield when buying dividend stocks. Sometimes a really high yield can be bad news, rather than good. Yield is calculated by dividing the dividend per share by the company’s share price. So if the dividend is 5p and the stock trades at £1, the yield is 5%. If profits slump and the share price crashes to 50p, that yield leaps to 10%. That looks great, but the company may struggle to fund shareholder payouts from shrinking profits.

I plan to live on a rising passive income

One way to work out if that passive income stream is sustainable is to examine the company’s dividend payout ratio. This is calculated by dividing the last full-year dividend by net profit. A number below 100% suggests payouts are affordable. I also examine dividend cover, and feel far more confident when the payout is covered twice by profits.

Forward earnings projections (and recent growth) may also indicate whether the company can continue to generate the cash it needs to deliver the rising passive income I crave.

Another way of seeing whether the passive dividend income is secure, is to examine prospects for the company’s sector. BP and Royal Dutch Shell have been a tremendous source of dividend income, but oil companies may struggle as competition from renewables grows.

Every company is exposed to unexpected shocks, as we have seen in the pandemic. I would improve the odds by targeting companies with loyal customers, strong balance sheets, minimal debt, and a defensive ‘moat’ against competitors.

Cash is 100% safe but is being eroded by rising inflation. By investing in top FTSE dividend stocks, my passive income will hopefully rise in real terms.

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Harvey Jones 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.

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