One of my preferred routes to earning a second income is by investing in dividend shares. That’s because I’d expect to receive regular payments that grow over time.
Recent spikes in inflation have shown why it’s important for income to at least keep pace with rising prices.
The second income plan
Today, I’m considering the best way to turn a Stocks and Shares ISA into an income-generating machine.
Passive income stocks: our picks
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?
If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…
Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.
What’s more, today we’re giving away one of these stock picks, absolutely free!
First, to create a £9,386 annual second income, I’d need a sizable pot to begin with. A single £20,000 investment is unlikely to be enough without taking excessive risks, in my opinion.
That said, by diligently investing £20,000 every year for just five years, I calculate that I should be able to build an ISA worth over £117,000. And given an 8% dividend yield, that should be enough to reach my income goal, although as always, it’s not guaranteed.
Finding dividend shares
The average dividend yield in the FTSE 100 is 3.8%, so I’d need to search a bit deeper to find suitable candidates.
Perhaps I could buy shares that offer the largest dividend yields. For instance, Vodafone currently offers a whopping 10%.
That might work out ok, but I’d consider a few other points before making my selection.
A large yield might not be sustainable. Bear in mind that dividends aren’t guaranteed. Company management can decide to cut, or suspend, payments if there’s a risk to earnings.
One way to measure affordability is by looking at its dividend cover. This shows how many times a dividend can be paid from a company’s earnings. To allow for a margin of safety, I’d consider any figure above 1.5.
Vodafone has a dividend cover of 1.0. And as that doesn’t meet my criteria, it’s not one I’d consider buying right now.
What I’d buy
Instead, I’d buy Phoenix Group, Legal & General, British American Tobacco, Aviva, and Lloyds Banking Group.
On average, this collection offers a yield of 8% and a dividend cover of 1.8.
On an initial £20,000, I’d expect to receive £1,600 of income in the first year. But while I’m building the pot over the first five years, I wouldn’t spend my dividends on clothes or gadgets.
Instead, I’d reinvest them to buy more shares. By doing so, next year I should receive dividends on my original shares and my new ones.
Reinvesting dividends like this has a powerful compounding effect that can amplify my income over time.
Comfort zone
My five chosen dividend stocks have been paying regular income to shareholders for many years, so they offer an excellent track record.
Although it doesn’t guarantee that they will continue to do so forever, it provides me with some comfort and reassurance.
Bear in mind that much can change to businesses, so I’d need to monitor the stocks I own to ensure they continue to offer reliable dividends. But with a small selection, that shouldn’t be too difficult.
If I’m patient, it may not be too long before my plan allows me to spend some of that second income. I already know what I’m going to buy.
