Generating passive income is a great idea. The best way to do this, in my view, is through buying dividend stocks. Even better would be to buy dividend stocks in an ISA. This way, the dividends would be tax-free, leaving me with more of the income to spend myself.
This is how I could aim to generate £1,000 in passive income each year using dividend stocks in my ISA.
£1,000 in passive income
I’ve chosen a target of £1,000 as it would give me some extra spending money over the year. Eventually though, I want to grow this to be much larger. I’ll explore how to do this at the end of the article.
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Now I need to make some assumptions. The £1,000 target depends on the dividend yields I can achieve from my investments. Luckily for me, the UK market is generally considered a good place to invest to generate dividend income. For example, the current 12-month dividend yield of the FTSE 100 is 3.6%, while the US equivalent index, the S&P 500, is only 1%.
To achieve £1,000 in passive income each year, a 4% dividend yield means my portfolio must be £25,000 in value. In a similar way, a 5% dividend yield requires a portfolio value of £20,000. A £20,000 portfolio is a great target to have because that’s the annual stocks and shares ISA allowance.
Now I have a goal to reach if I want to generate £1,000 in passive income.
Stocks with high dividend yields
At time of writing, there are 22 stocks in the FTSE 100 with dividend yields that are 4% or above, and 16 stocks with yields of at least 5%.
If I went with the larger dividend yield target of 5%, then I could buy all 16 stocks in my portfolio and equal weight them at £1,250 per holding. This would total the £20,000 portfolio value I would need to generate at least £1,000 in passive income.
I also have to remember that I’d incur dealing costs too, of course, and that a 16-stock portfolio might be considered too risky given the concentration in each position. If I chose the 4% dividend yield stocks, I would need a portfolio value of £25,000, and each position would be £1,136 in size. This spreads the risk across 22 stocks instead.
Final thoughts
The analysis here did not go deep enough into the companies themselves. This would be important to do before buying any of the stocks in my portfolio.
Therefore, another strategy could be to simply buy the iShares FTSE 100 (LSE: ISF) ETF, which tracks the entire index and generates a dividend yield of 3.6%. My portfolio value would have to be about £28,000 in this case, but at least the portfolio would be diversified across 100 stocks and buying one stock only would cut my dealing costs.
Over time, I’d want to increase my passive income above £1,000 by using dividend stocks. The way I would do this is by setting up a direct debt each month of £100 and automatically investing it into my ISA. This way, I’d have saved an extra £1,200 each year, which would then earn extra dividends in my portfolio.
