Archived article: Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
The idea of creating an income stream in which you get paid without working is nothing new. It’s actually the fundamental basis of any retirement plan. However, the concept has been repackaged as ‘passive income’ in recent years, as people of working age seek to make more of their assets and abilities to boost their income. It covers all sorts of activities from hiring out garden tools to renting out a room to lodgers.
There is almost always an upfront cost to creating passive income, but the idea is that it requires little continued effort to keep the money rolling in. Building up a portfolio of income investments fits neatly into this category. Once you’ve saved enough for a portfolio which provides you with a reasonable income, your working options open up, whether that might be going part-time, retiring early, or retraining in a new field.
How much you need to build up depends on what your income needs are. You should usually be able to get a yield of somewhere in the region of 4% from a portfolio of investments, so to have a £10,000 annual income, you would need a pot of around £250,000. You might be lucky enough to receive some or all of that from an inheritance, or you may already have some savings, but if you have to build it up entirely yourself from scratch, you would need to stash away £6,000 a year for 21 years, based on receiving 6% growth from your investments annually after charges. That may sound like a long haul, but so is renting out a room in your house when you consider you’ll be paying back the cost of the property over a standard mortgage term, typically 25 to 30 years.
Once you’ve built up your capital, you’ll need to invest it for income. One way of doing this is to invest in individual stocks. There are plenty of companies in the UK stock market which provide relatively healthy dividends, though high yields are not necessarily the only indicator you should look at when selecting investments. A historic dividend yield provides you with information on what the company has paid out in dividends in the last year, but sometimes the market adjusts the price of a stock downward because it’s expecting dividends to be cut. That can result in a historic yield which looks high because it relates to last year’s dividends, which aren’t repeated going forward.
How do I choose the right dividend-paying stock?
Investors should also consider the dividend cover of a stock, which is the amount by which its earnings cover its dividend. This is given as a multiple, for instance a dividend cover of 2x means that annual earnings are two times bigger than annual dividends, which suggests a company can continue to pay out its dividend unless earnings fall by 50% (though of course it may still choose to cut its dividend if its earnings fall by less than that). On the other hand, a company with a dividend cover of 1x is skating on thin ice in terms of its income payments, because any reduction in earnings could well mean having to cut the dividend, or fund it by taking on more debt.
Another couple of considerations when picking income shares is dividend volatility and dividend growth. Some sectors have more volatile dividends than others. For instance, consider mining companies, which derive their earnings from commodity prices. When these are high, the money is rolling in, and dividends can be generous. But when the cycle turns and commodity prices fall, mining companies can see their profits collapsing and might have to take an axe to dividends. Compare this with supermarkets, where demand for their products is relatively stable, and so their profits and dividends are less volatile.
Dividend growth in the future should also be factored into investment decisions. A company with a high stable dividend may give you jam today, but if the dividend remains flat over time, your income is vulnerable to the effects of inflation. A company which has a good track record of growing its dividend can offer you some protection here, though there is of course no guarantee it will continue to do so indefinitely into the future. Stocks with higher dividend growth potential tend to come with lower starting yields. An income portfolio might therefore include stocks with a high but flattish dividend to boost income in the here and now, alongside companies with lower yields but better prospects for dividend growth.
Considering income funds
To run a truly portfolio of individual stocks you really need a minimum of 25 to 30 companies to achieve an adequate level of diversification, to protect you from problems in one company or sector damaging your wealth too badly. For many people, that’s a lot of portfolio management to take on, which is where funds come in. An income fund run by a professional investment manager offers you instant diversification, as well as someone to pick stocks on your behalf.
There is of course a fee for managed funds. The average UK Equity Income fund (investing in UK income stocks) levies an ongoing charge of 0.81% per annum (according to AJ Bell analysis of Morningstar data) and that comes on top of the cost of platform fees. Equity income funds investing outside the UK can also help you diversify your portfolio globally and are definitely worth considering. You may have to accept a lower yield from some markets, but sometimes that might come with better prospects for capital growth.
Like open-ended funds, investment trusts also offer a diversified portfolio of shares and are run by a professional manager. Income trusts can also manage dividend payments to their shareholders by holding back money in good years to distribute dividends when the companies the trust is invested in aren’t paying out very much. This doesn’t mean investment trusts receive more dividends than an equivalent open-ended fund, but they can smooth the income as it is paid out each year, which will be attractive to some investors.
Receiving income from bonds
As well as shares, investors seeking income should also give some consideration to bonds. For many years while interest rates were low, bonds offered very low levels of income, but that’s all changed now. The UK 10-year gilt is now yielding 4.7%, up from less than 0.5% just five years ago. This means bonds are back on the radar for income seekers. Investors can buy individual bonds, or a bond fund which is professionally managed and spreads risk across a portfolio of securities. Some bond funds invest in government bonds, while others invest in corporate bonds, and some hold both.
The great thing about holding some bonds as well as shares for income investors is that they tend to move in opposite directions. This helps to reduce the volatility of your portfolio as a whole, while also diversifying your sources of income. For those who don’t want the bother of selecting or running their own portfolio of equity and bond funds, a multi-asset income fund might be the order of the day. These funds come in a variety of risk profiles and invest in shares, bonds and cash, sometimes adding property, infrastructure, gold, and other alternative assets. They are a convenient solution for income seekers who want to keep risk in check without managing a portfolio themselves.
How to save on taxes through using an ISA
It goes without saying if you’re investing for income, you should keep the taxman off your dividends and bond interest payments. By holding your investments in an ISA, your income from investment faces no income tax, and no capital gains tax. You do have an annual dividend allowance which lets you receive £500 of dividends tax-free each year, but anything above that is taxable at 8.75% for basic rate taxpayers, 33.75% for higher rate taxpayers, and 39.35% for additional rate taxpayers. By holding your investments in an ISA, you don’t have to pay this tax.
Likewise for bond interest the Personal Savings Allowance allows basic rate taxpayers to receive £1,000 of interest each year tax-free, which falls to £500 for higher rate taxpayers and £0 for additional rate taxpayers. That includes interest from bank accounts too. Any amount above this is taxable at 20%, 40% or 45%, depending on whether you’re a basic, higher or additional rate taxpayer, respectively. Again, by holding your bonds in an ISA, you simply don’t have to pay this tax. So whether you’re investing in shares, bonds, or a combination of the two, making the most of your ISA allowance to save tax and keep more of your income is a bit of a no brainer.
Laith Khalaf: Head of Investment Analysis
Laith Khalaf is AJ Bell's Head of Investment Analysis. He joined the company in 2020 and continues to explore the world of personal investing, providing research and analysis to both AJ Bell customers and the...
