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Some passive income ideas are simpler than others: a batch simpler.
For example, my own approach is to buy blue-chip stocks in proven businesses that I hope can pay me regular dividends for years or even decades without me lifting a finger.
I like the fact that I benefit financially from large-scale companies that have already proven that they can make money.
But what if I make some passive income and then have to pay a big chunk back to the taxman? To avoid that, I use a stocks and Shares ISA.
However, even in an ISA, fees and costs can affect dividend income. Therefore, I think it makes sense for each investor to make their own choice as to which ISA might best suit their individual situation.
Please note that tax treatment depends on each client's individual circumstances and may be subject to change in the future. The content of this article is provided for informational purposes only. It is not intended to be, nor does it constitute, any type of tax advice. Readers are responsible for conducting their own due diligence and obtaining professional advice before making any investment decisions.
Determine the size of dividend income
There are three factors at play when determining how much passive income someone can expect to receive from the stocks they own.
First is how much someone invests In this example, that's £20,000.
Second comes the average dividend yield cattle in a wallet. That is, the annual dividends as a percentage of the investment. So, for example, £500 a year is equivalent to a 2.5% return on £20,000. This seems easily achievable to me and is in fact well below the average performance of FTSE 100 actions right now.
By contrast, £5,000 would mean a 25% return. Not only is it much higher than any FTSE 100 share offering, it is so high that I see it as a red flag. If a stock offers a 25% yield (and some occasionally do), it often suggests that the market expects a dividend cut.
But there is a third factor at play: How long does an investor hold stocks?.
If an investor reinvests dividends initially (a simple but powerful financial technique known as compounding), the long-term return could be higher than today.
For example, adding a £20,000 ISA at 7% a year, after 19 years it should produce over £5,000 a year in passive income.
Yes, it's a long time to wait. But this is a serious long-term investing approach, not a ridiculous get-rich-quick scheme.
Find stocks to buy
The good news is that I believe the current market offers realistic opportunities to achieve an average annual return of 7% while still sticking to the blue-chip FTSE 100 stocks.
Investing in several different stocks reduces the risk if one disappoints, for example by cutting its dividend.
One dividend stock I think investors should consider is M&G (LSE: MNG).
M&G's yield stands at 10%. Your goal is to maintain or increase your dividend each year. This is not guaranteed to happen in practice, but the asset manager has increased its dividend per share annually in recent years.
With a large target market, millions of customers spread across multiple markets, a strong brand and deep industry experience, I think M&G could well continue to offer its products.
One risk is that clients withdraw more funds than they put in. That happened in the core business in the first half of last year and it's a risk I'm watching out for.
Meanwhile, as an M&G shareholder, I continue to be attracted to the prospects of passive income.
