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In my view, purchasing UK dividend shares is the best way to target a long-term second income. The FTSE 100 alone is packed with exceptional dividend growers (like BAE Systems and Ashtead) and income stocks with enormous dividend yields (such as HSBC and Legal & General).
The long-term forward dividend yield on Footsie shares is 3% to 4%. With some careful stock selection, I think investors can create a portfolio that delivers a large and increasing long-term second income.
Here are three smart steps for you to consider to target a large passive income in retirement.
Set an income target
The first task is to work out how much money you’ll need in retirement. Let’s say you want an extra £20,000 on top of what the State Pension offers. You’ll have to build your portfolio in a way that targets that figure.
With an average dividend yield of 5%, you’ll need a portfolio worth £400,000 invested in dividend shares. With a yield of 6%, that figure drops to £333,000.
I prefer the idea of investing in dividend shares to purchasing an annuity or drawing down a set percentage each year. This method can provide a reliable income while allowing for further portfolio growth.
Think about tax
The next step is to stop taxes from taking a chunk out of your cash. Any slice it takes from an investor’s profits can negatively impact compounding — the snowball effect of reinvesting returns to boost portfolio growth.
So it’s important to find a financial product that eliminates one’s tax burden. The Individual Savings Account (ISA) is one such popular product.
The Stocks and Shares ISA has an annual investment allowance of £20,000, and makes capital gains and dividend income completely tax free. The Lifetime ISA provides the added benefit of tax relief investors can use to build better compound returns.
However, the allowance with the Lifetime ISA is lower at £4,000. And withdrawals before the age of 55 (57 from 2028) come with penalties.
Also, withdrawals from either ISA in retirement aren’t subject to income tax
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Diversify into different stocks
The final step is to build a diversified portfolio to reduce risk and capture a range of growth and income opportunities. Investment trusts like the Fidelity European Trust (LSE:FEV) are powerful weapons in helping investors try to achieve this.
With holdings in 43 companies, this specific trust is well diversified by both country and industry. To give you a flavour, major holdings here include Dutch semiconductor maker ASML, Swiss drugs developer Roche, and French energy producer TotalEnergies.
I also like this trust because of its focus on large, established companies (almost all its constituents have market caps above £10bn). This provides extra stability, though be warned: this can result in lower capital growth than trusts holding smaller growth shares.
Through a mixture of capital gains and dividend income, Fidelity European Trust has delivered an average annual return of 10% since 2015. If this continues, an investor seeking a portfolio of £333,333 would need to invest £206 a month over 25 years.
Investing this amount in 6%-yielding shares could generate our targeted £20,000 annual income. This assumes the yield remains steady over time, which isn’t guaranteed.
