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

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.

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.