How to earn £20k a year in passive income by investing £10 a day

Earning passive income is a compelling reason to invest in the stock market. The freedom and flexibility that regular dividend payments can provide is priceless, especially considering the minimal effort involved compared to the hard graft of a day job.

But how much should I invest in dividend shares to secure a healthy passive income stream?

Here’s how I’d target a £20k annual second income by investing just £10 a day.

Dividends

First, it’s important to understand what dividends are. Essentially, they’re regular cash distributions paid to shareholders — often semi-annually or quarterly.

Not all companies pay dividends. Some don’t have sufficient profits and others prefer to reinvest profits to prioritise capital growth.

That said, UK investors have plenty of choice. Both the FTSE 100 and FTSE 250 indexes boast a large number of dividend stocks in their ranks.

Tax considerations are important when it comes to dividend investing. The tax-free dividend allowance has been halved to £1,000 this year, and it will be slashed again to £500 next year. Accordingly, I’d shelter my investments in a Stocks and Shares ISA to maximise my potential returns.

Investing early, little, and often

Building a healthy dividend portfolio doesn’t require a fortune, but it will demand financial discipline and a long time horizon. I’ve set an achievable target of saving and investing £10 a day — or £3,650 a year.

I’d aim for a 4% dividend yield across my stock market holdings. Considering the FTSE 100 currently yields 3.7% and the FTSE 250 yields 3.2%, I think that’s a reasonable goal.

This means I’d need a total portfolio value of £500,000 to produce £20k in annual passive income.

Assuming an 8% compound annual growth rate on my stocks (from share price gains and dividend reinvestments), I’d hit my target in a little over 30 years. That’s not too shabby from setting aside just a tenner a day!

Risks

My calculations illustrate the power of compound returns. However, in reality, it’s a little more complicated.

During bear markets, my portfolio would probably shrink in value. With a time horizon spanning three decades, the chances are I’d encounter a few along the way. Extended periods of poor stock market returns would delay my progress towards my target number.

In addition, dividends aren’t guaranteed. If I made poor stock picks, I might invest in companies that cut or suspend their regular distributions. Accordingly, my portfolio’s yield could end up being lower than anticipated, which means I’d need to invest a greater sum.

Diversification

One way to mitigate these risks is to diversify my portfolio across different sectors, geographies, and company sizes.

For instance, I currently own various dividend stocks, including US soft drinks titan Coca-Cola (3% yield), FTSE 100-listed tobacco giant British American Tobacco (8.4% yield), and FTSE 250-listed gold miner Centamin (3.8% yield).

All of these companies face potential risks to their dividends. However, by spreading my exposure across a diversified mix of stocks, I hope I could rely on regular passive income streams from at least some of my holdings if any individual company encountered difficulties.

If all goes to plan, by following these steps, I could secure a £20k second income for the modest sum of £10 a day!

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.