I’d like to set up a passive income plan that can earn money without much input from me. One of the ways I can do this is by investing in the best dividend shares.
Dividend shares offer above-average cash payments to shareholders such as myself. The FTSE 100 currently has a dividend yield of around 4%. That doesn’t sound too bad to me. But some shares offer so much more.
Sustainable dividend shares
For instance, housebuilder Persimmon currently yields a whopping 15%. Yet that’s unusually high. You see, it’s not just about buying the largest yield. I want to make sure its dividends are sustainable.
Bear in mind that companies can cut or suspend dividends if earnings tumble or uncertainty spooks management. If I aim to receive £1,000 in dividends from a company that decides to cut its payout in half, I wouldn’t be a happy bunny.
So if I find 4% too low, and 15% too high, what level of yield should I look for? For me, the sweet spot is around 5%-10%.
If I invest £250 a month in dividend shares, how much passive income could I earn at that level? Over a year, I’d be investing £3,000. If my basket of dividend shares offers an average 8% yield, that equates to £240 of passive income.
That doesn’t sound like much, but it should grow over time. Stocks and shares also work best over long periods. One reason for that is due to dividend reinvestment.
Boosting passive income
Let me explain. Instead of spending my passive income straight away, I could reinvest it by buying more of my favourite shares. In turn, these new shares would send me additional dividends.
By continuing this process, my passive income should get a boost and grow over time.
To illustrate, I’d use this example. Let’s say I continued this plan for 30 years without reinvesting my dividends. At the end of the period, I calculate I’d have a pot worth £201,600.
But by reinvesting dividends, my total pot would be around £340,000. That’s an extra 69%.
That’s an amount that I wouldn’t want to ignore. Assuming I reinvest my dividends, I could build a pot large enough to provide me with a passive income of around £27,000 every year for life.
Best shares for income
To find the best dividend shares, in addition to a 5%-10% yield, I’d look for a few other qualities. For instance, I like to see a long history of paying dividends. Companies that have paid out regularly for many years look more reliable than those that have just started.
I also want to see signs that a business can afford to pay my dividends from its earnings. For this, I’d look for dividend cover of more than one.
Ideally, I’d want to invest in a business that’s growing its earnings. If it can do that, then there’s a chance that it can potentially raise its dividend payment over time.
Overall, there are several shares that meet my criteria. Right now, I’d buy Rio Tinto, Phoenix Group Holdings, Taylor Wimpey, Legal & General and Imperial Brands. On average, they currently offer a 9% yield. That’s right in my sweet spot.