How I’d try to turn an ISA into £10,000 of passive income

UK shares offer ample opportunities for reliable passive income. Our writer outlines what he’d look out for and what he’d buy.

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One of my favourite ways to earn passive income is from dividend shares. That’s because they offer regular income and potential growth.

Dividends are typically paid every quarter. And although the average FTSE 100 dividend yield is around 3.5%, several stocks pay far more. For instance, some Footsie shares pay up to 10% a year.

Bear in mind that the highest-yielding stocks aren’t necessarily the best options for reliable passive income. High yields might not be sustainable and could indicate a risk of an upcoming dividend cut.

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That’s why investors should also consider a stock’s dividend cover. This measure outlines how many times its dividend can be paid by current earnings. For instance, a dividend cover of two implies that the company can afford to pay double its current dividend from its net profits.

Hidden value

Another factor that’s often overlooked is dividend growth. Companies that manage to grow their payouts over time can be far more lucrative to investors in the long term.

Consider Warren Buffett’s investment in Coca-Cola. This drinks giant has raised its annual dividend a whopping 61 years in a row. The result of this is that Buffett’s Berkshire Hathaway expects to earn $704m in annual dividend income.

That’s remarkable considering its shares only cost $1.29bn as they were mostly bought over 30 years ago.

Passive income strategy

To target a £10,000 annual passive income, I’d need a sufficiently large pot of money. By building a basket of the best dividend stocks, I’d hope to earn a 6% yield on average. I calculate I’d require around £167,000 to achieve my goal.

Note that by targeting a chunky 9% dividend yield, I’d only need around £111,000.

To produce a tax-efficient annual income, I’d start the process in my Stocks and Shares ISA. My first step would be to select a basket of five-10 UK-based dividend shares.

Ideally each company would operate in different sectors. That should prevent me from putting all my eggs in one basket.

I’d look for shares that offer reasonable dividend yields, and payouts that are comfortably covered by earnings.

Which dividend stocks?

Right now, some UK shares that offer substantial and reliable dividends include Aviva, Glencore, Legal and General, HSBC, and British American Tobacco.

This group offers an 8% yield, and a dividend cover of 1.7x. That sounds appealing to me.

Shares that have a solid track record for dividend growth include Ashtead, London Stock Exchange, and RELX. On average, their dividends have grown by 14% a year over the past decade. That said, at around 2%, their yields are currently much lower than the first group.

But like Buffett, I’d be willing to accept this slightly lower dividend yield for the chance to receive much higher payouts in the future.

Overall though, I prefer to own both types. And if I had a chunky pot to invest for passive income right now, I’d buy all eight of these shares.

But here’s another bargain investment that looks absurdly dirt-cheap:

Like buying £1 for 31p

This seems ridiculous, but we almost never see shares looking this cheap. Yet this Share Advisor pick has a price/book ratio of 0.31. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 31p they invest!

Of course, this is the stock market where money is always at risk — these valuations can change and there are no guarantees. But some risks are a LOT more interesting than others, and at The Motley Fool we believe this company is amongst them.

What’s more, it currently boasts a stellar dividend yield of around 10%, and right now it’s possible for investors to jump aboard at near-historic lows. Want to get the name for yourself?

See the full investment case

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

HSBC Holdings is an advertising partner of The Ascent, a Motley Fool company. Harshil Patel has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended British American Tobacco P.l.c., HSBC Holdings, and RELX. 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.

Our best passive income stock ideas

Do you like the idea of dividend income?

The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?

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