Investing in dividend stocks can be a great way to earn a second income. With no tax due on dividends or capital gains and a £20k annual allowance to take advantage of, I’d use a Stocks and Shares ISA to pursue this goal.
But, how long would it take me to generate £40k in dividends every year starting from zero? Let’s crunch the numbers.
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Buying dividend shares
Since earning passive income is my chief objective, I’d focus on maximising my portfolio’s yield by investing in dividend shares.
UK investors are spoiled for choice. Compared to other leading global stock market indexes, the FTSE 100 and FTSE 250 have some of the highest concentrations of income-producing companies.
When searching for dividend stocks to buy, it’s important to look beyond the headline yield figure. Robust dividend cover and a reliable history of shareholder payouts are crucial factors that influence my decision to invest.
That’s because I prioritise dividend sustainability. Although no distributions are guaranteed, some stocks carry lower risks than others. Generally, dividend cover of two times earnings or more is a good indicator of safety.
Examples of dividend shares I own include:
| Stock | Dividend Yield | Dividend Cover |
|---|---|---|
| Diageo | 2.4% | 2.0x |
| Lloyds | 5.6% | 3.0x |
| Tesco | 4.4% | 2.0x |
I wouldn’t confine myself to British shores either. An attractive way to gain overseas exposure could be to invest in an exchange-traded fund (ETF), such as the ProShares S&P 500 Dividend Aristocrats ETF.
This fund tracks the performance of the S&P 500‘s Dividend Aristocrats — companies that have consistently hiked their dividends for 25+ years.
Compound returns
Imagine I secured a 4% dividend yield across my holdings. That means I’d need a £1m stock market portfolio to earn a second income of £40k per year.
If I maximised my ISA contributions every year starting with nothing, it would take me a little over 20 years to achieve that goal at an 8% compound annual growth rate (CAGR), accounting for capital gains and dividend reinvestments.
Although an 8% CAGR is in line with the stock market’s historic performance, it’s prudent to model different rates of return. After all, past performance doesn’t guarantee future returns.
For instance, at a 6% CAGR, I’d need to expand my investment horizon to over 23 years. And at a 4% CAGR, I’d need to wait nearly 28 years until my annual dividend haul reached £40k.
In addition, it would be challenging to contribute £20k every year to an ISA. But, for investors who can afford it, the tax-free rewards are potentially great.
Risk management
Dividend investing isn’t risk-free. As I’ve alluded to, companies can cut or suspend their dividends if they encounter financial difficulty — including the examples I’ve provided in this article.
If companies I owned reduced payouts or stopped paying me passive income altogether, that would derail my neat calculations.
Diversification is a useful way to manage these risks. By spreading my investments across different businesses and sectors, I wouldn’t be overly reliant on any single stock to earn a second income.
Plus, the potential rewards over time are significant. Cash savings have rarely kept pace with inflation over long periods, so I’m buying dividend stocks to meet my passive income needs.
