Banking £5,000 a year in passive income from FTSE 100 shares would give me an extra £416 every month to spend or reinvest as I see fit.
Of course, that won’t necessarily happen overnight. First, I might need to build up the right portfolio of FTSE 100 shares, preferably inside a Stocks and Shares ISA.
But as I’m building my portfolio of income stocks, I’ll also be reinvesting those dividends rather than spending them. That way, due to the power of compounding, I’ll potentially reach my £5,000-a-year passive income target a lot sooner.
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Being picky with high yields
When it comes to FTSE 100 shares, those with the highest dividend yields may not always be the best options.
For example, shares of housebuilder Persimmon (LSE: PSN) were yielding over 15% earlier this year. But interest rates and borrowing costs have been rising sharply over the last 12 months. This has caused a slowdown in the UK housing market and much uncertainty.
As a result, Persimmon issued a profit warning and slashed its dividend by 75% at the beginning of March. So that massive yield was essentially a mirage and the shares now yield around 6%.
While a 6% yield is certainly nothing to be sniffed at, it’s not the eye-popping income bonanza I might have assumed I was set for.
So, I always need to bear in mind that the dividend yields I’m looking at are likely to be trailing yields. That is, they’re based on the past 12 months of payouts and are therefore backwards-looking.
Future dividends may be higher or lower, depending on a whole range of company-specific and macroeconomic factors.
Often then, it pays to be picky when choosing high-yield FTSE 100 shares.
The benefits of diversification
It’s also a good idea to choose at least a dozen or so FTSE 100 shares across different sectors.
Diversifying my holdings like this will cushion the blow if one stock doesn’t pay out. And it’ll also minimise the downside when a particular sector — such as housebuilders recently — encounters difficulties.
Fortunately though, there’s a whole raft of Footsie dividend shares out there that look attractive to me right now. These include insurers Aviva and Legal & General, with forward yields of 8.7% and 9%, respectively.
Also, the shares of mining giants Glencore and Rio Tinto appear enticing. They have forward dividend yields of 8.1% and 6.8%, with the respective payouts covered 1.55 and 1.65 times by anticipated earnings.
Finally, and ironically enough, Persimmon’s 6% yield has started to pique my interest. Granted, the outlook for the UK housing market remains murky (at best) and interest rates may be heading above 6% next year.
Yet with the share price already down 62% in 18 months, I’m starting to think the bottom may be near.
A patient mindset
The average dividend yield on the shares I’ve just mentioned is 7.7%. So, if I were looking to generate £5,000 in annual passive income straight away, I’d need £65,000.
But as mentioned, I could also put aside some money each month to invest and build out my position over time.
By reinvesting those meaty dividends and letting them compound, I’ll reach my £5,000 of annual passive income in due time.
