Unless I win the lottery, I’m not expecting a lavish retirement. But my final years will be a lot easier if I can build up some passive income, on top of my State Pension. One way I’m doing this is to invest in UK shares, which offer some of the most generous dividends in the world. This income stream is tax free, if bought inside a Stocks and Shares ISA.
Dividends are the regular payouts companies make to reward shareholders for buying and holding their shares. Today, I’d reinvest those dividends straight back into my portfolio, to pick up more stock. Then, when I reached retirement, I would draw them as passive income.
I’d invest in a tax-free Stocks and Shares ISA
I’ve set myself a target of generating £500 a month in retirement, which adds up to £6,000 a year. Ideally, I’d want more than that. Especially if inflation continues to ravage the value of my money in real terms. So how much do I need to generate that level of passive income?
Partly, the answer depends on which shares I buy, because every company has different yields. Yield is calculated by dividing the dividend per share by the share price.
Last year, housebuilder Persimmon paid (very generous) dividends of 235p per share. At the time of writing, its stock trades at 2235p. That would suggest a current yield of 9.51%. Yields change all the time, and Persimmon’s forecast income stream is now actually 10.4%.
Here’s how I’d build my passive income stream
If I put all my portfolio into a stock yielding 9.50%, I could generate £500 a month passive income from a lump sum of just £63,000. However, I would never do that. Buying just one company is way too risky, because even the best firms can hit problems. They could cut their dividend, scrap it all together, or even go out of business.
So I would buy a spread of shares to generate a more secure passive income. But this also means building up a larger chunk of capital. Companies listed on the FTSE 100 currently pay an average yield of 3.52%. At that rate, I would need £170,454 to generate the same £500 monthly passive income.
Building up such a sum is achievable, but it takes time. If I had 20 years before retirement, for example, I would have to save £375 a month, assuming my portfolio delivered an average total return of 6% a year. It might return less, of course. Or more. That’s the risk all investors take.
If I had 30 years, I would only have to invest £175 a month to build the same sum. That’s why it pays to start investing early in life. However, I would swing the odds in my favour by focusing on generating my passive income from FTSE 100 stocks offering higher yields.
Mining giant Rio Tinto currently yields an incredible 11.10%. Insurer Aviva and asset manager M&G yield 8.66% and 8.40% respectively. Miner Antofagasta, insurer Phoenix Group Holdings and fund manager Abrdn all yield around 7.5%.
Higher-yielding stocks can be riskier, but would turbocharge my plans to build a passive income of £500 a month. They might even give me a lot more.