There are many passive income ideas floating around these days. But my favourite method involves dividend shares.
I’d describe these as shares that pay an above-average dividend to shareholders like myself. Dividends are typically paid from company profits, and they can provide a regular form of passive income.
Top dividend shares
The average dividend yield for FTSE 100 shares is currently 3.7%. That equates to £370 of cash on a £10,000 investment.
That’s not too bad, but I could receive much more if I pick and choose individual shares. For instance, the largest dividend yield in the Footsie right now is housebuilder Persimmon, which pays over 13%.
Next, comes global mining giant Rio Tinto, which carries a dividend yield of 12%.
Bear in mind that payouts aren’t guaranteed, and a company can suspend or reduce them if it experiences a drop in earnings. That’s why I reckon it’s important to look at dividend quality too.
Reliable dividends
I’d want to pick shares that provide reliable dividends. They should ideally have a good track record over many years.
To spread my risk, I’d also try to pick shares from different industries. That way I won’t be putting all my eggs in one basket.
Right now, several shares meet my criteria. In addition to Rio and Persimmon, I’d also consider Phoenix Group, Imperial Brands and SSE.
One more thing to bear in mind is that share prices can rise and fall. So despite receiving a chunky dividend, the value of my shares still carry a chance of dropping and I could lose money.
That said, my share picks are well-established businesses that should be able to withstand difficult times, in my opinion.
Setting up a passive income plan
Once I’ve picked my stocks, I’d look at how to set up a passive income plan. I’d start by deciding how much I want to invest regularly. Right now, I’m going to save £200 a month. Over time I can add more funds when I have more money available.
Next, I’d split my investment equally between my five selected stocks. If I bought all five of these shares, I could receive an average of 9% in dividends every year. After one year, that equates to around £216.
Over time, all these dividends can add up to a tidy sum. But next, I have an interesting dilemma. I could withdraw these regular payments as passive income every year and spend it on something nice.
Alternatively, I could reinvest them to buy more shares.
Dividend reinvestment is a powerful concept that could boost my passive income in the future.
By deferring this income, I could potentially receive much more at later date.
I calculate that if I buy more of my selected shares with the dividends every year, after 10 years I’d have a pot worth around £36,500. That’s enough to earn an annual passive income of approximately £3,300.
Note that if I don’t reinvest my dividends, I would receive around £2,160 over that period instead.
Personally, I’d rather defer and wait for a higher income.