Passive income is the perfect way to continue receiving an income after retirement. My pension will only stretch so far, so if I want to retire early, I’ll need something extra.
I think the best way to do this is with a portfolio of shares that pay dividends.
How dividends work
A dividend is like a small gift that companies pay their shareholders every year as a thank-you for investing in them. A 5% dividend yield on a £1 share would pay me 5p for each share I hold. This is in addition to any returns made if the share price increases.
Dividends on shares are calculated annually, although often paid in two or four payments a year. Subsequently, my plan would involve building a portfolio of dividend shares that pay approximately £12,000 a year.
Once the passive income stream has been established, I can begin withdrawing my returns as needed.
Dividend yields change regularly, so it’s impossible to know how much I’ll receive each year. But with a portfolio of well-selected stocks, I can aim for a conservative average of around 5%.
How my strategy could work
I’ll use the small-cap iron casting and machinery firm Castings (LSE:CGS) as an example.
Its 5% dividend yield is lower than many other UK stocks but it has an excellent track record of making regular payments. I’d aim for a good mix of reliable low-yield dividend shares and less reliable high-yield shares.
Furthermore, it’s currently estimated to be trading at 58% below fair value so could go up from here. I don’t want to dive into an overvalued dividend stock that could lose value and negate any returns I make from dividends.
On the downside, Castings earnings are forecast to grow at only 3.1%, slower than the UK average of 12.6%. Still, the dividend payments make it worthwhile.
I’ve calculated that I could reach my goal of £1,000 a month in passive income in 20 years with the following strategy.
My outcome is based on a 5% dividend yield with semi-annual payments and an expected 0.2% annual dividend increase. I’ve also calculated an expected 6% annual share price increase. This is based on the past performance of an average basket of well-performing FTSE stocks.
First, I’d invest £12,000 into a portfolio of shares similar to Castings
I’d use a dividend reinvestment plan (DRIP) to put any dividends earned back into the investment
I’d contribute an additional £200 a month to the investment
In 20 years, my investment could have grown to £257,395. At this point, my average annual returns with dividend payments could be £12,081 – just over £1,000 a month.
Risks
There are risks involved with such a strategy. I can’t guarantee the dividend payments will be consistent, or remain at 5%. The share price of any stocks I include could also fall, resulting in financial losses.
For this reason, I need to carefully research all the stocks I add to my portfolio. I should ensure they have a solid history of growth potential and a track record of making reliable dividend payments.
The post How I plan to retire early with £1,000 a month of passive income appeared first on The Motley Fool UK.
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Mark Hartley has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
