One of the great aspects of investing is that our portfolio can be a source of passive income. I'm looking here at how much you'd need to have invested to earn passive income of $10,000 in a year - and I'm talking about ongoing income such as interest, dividends or fund distributions as opposed to capital gains. After all, we want to keep as much of your money invested as possible so it continues to generate returns.
Why $10,000? Because right now that sort of money would go a long way towards paying household bills. Or it could fund a decent family holiday each year, or help send the kids to the school of your choice.
As we'll see, earning $10,000 in passive income doesn't just depend on the investments you select. It can also hinge on how those investments are taxed. So, it can pay to speak to your accountant for strategies to minimise tax on your returns.
Options to earn $10,000 a year
For the purpose of this analysis I'm going to overlook residential property. Yes, I know a rental property can be a source of regular, passive income. However, for most people, investing in property also means taking on a significant debt and committing to the regular upkeep of the place. The costs involved can see a property deliver negative cash flow, at least until it is owned debt-free.That being the case, I'll focus on other investments:
1. Savings accounts
The upside of today's high interest rates is that we are seeing savings accounts paying solid returns.
That said, it pays to read the fine print. Plenty of savings accounts require consumers to meet strict conditions often involving minimum deposits, or maximum withdrawals, in order to earn a high return.
It can be challenging to tick all the boxes month after month. A report by consumer watchdog, the ACCC, found that in the first half of 2023, 71% of bonus interest accounts did not receive bonus interest at all.
If you're prepared to shop around it's possible to make your spare cash work hard without having to jump through hoops. Macquarie Bank's transaction account, for example, is paying 4.75% on balances up to $1 million. There are no strings attached and no conditions to meet.
It's a similar story with Unity Bank's MoneyMAX account, which also pays 4.75% with zero conditions. At that rate, you'd need $211,000 on deposit to earn passive income of $10,000 annually.
If you're committed to meeting various conditions to earn bonus interest, some of the top payers include ME Bank's HomeME home deposit savings account (5.55%), and Rabobank's PremiumSaver (5.45%). Assuming you can score a rate of, say, 5.50%, you would need savings of $181,818 to earn interest income of $10,000 annually.
Alternatively, term deposits can be worth a look.
Plenty of providers are paying above 5.0% across a range of terms. However, rates on longer terms tend to be lower, which suggests banks are expecting market rates to fall.
G&C Mutual Bank, for instance, is paying 5.05% on a one-year term, falling to 4.85% over two- and three-year terms. Judo Bank is paying a return of 5.25% for one-year deposits. With plenty of economists predicting that rates will fall in late 2024 or early 2025, it may pay to spread your money across a range of terms to potentially lock in high rates before they head back down.
The beauty of savings accounts is that the Financial Claims Scheme (FCS), which is a government-backed safety net, applies for deposits up to $250,000 per account holder per authorised deposit-taking institution. So, we're talking about a very safe investment.
The downside is that interest on savings accounts is fully taxable. Passive earnings of $10,000 could be whittled down - almost by half - if you are a high-income earner.
2. Shares
Shares don't just have the potential to deliver capital growth. Shareholders can also receive twice-yearly dividends.
The drawback is that dividends (like capital growth) are not guaranteed. They are paid at the discretion of the board of directors. As we saw through the pandemic, some blue-chip companies opted to preserve their cash by opting out of paying dividends.
Thankfully, those extenuating circ*mstances are behind us. But COVID was a powerful reminder that listed companies don't have to pay dividends. They can also decide to increase or reduce dividend payouts in line with the company's trading results and future plans.
That said, some companies have a stronger reputation than others for paying dividends. Some of the leading big-name dividend payers over the past 12 months include:
New Hope Corporation (ASX: NHC):9.28%
Fortescue Ltd (ASX: FMG): 8.55%
Westpac (ASX: WBC): 6.05%
Based on these yields, if you wanted passive income of $10,000 a year, you would need to hold around $108,000 worth of shares in New Hope, around $117,000 worth of Fortescue shares, or about $166,000 in Westpac stocks.
If the dividends are fully franked, meaning they have been paid out of profits on which the company has paid tax of 30%, they can be lightly taxed in the hands of shareholders. Low-income earners can even receive a tax refund for the company tax paid, which is a significant boost to passive income without an associated tax bill.
Dividend yields are calculated based on the cash dividends paid - which the board decides as a cents-per-share figure, expressed as a percentage of the company's current share value. If a company's share value falls, its dividend yield rises.
A company can have a high dividend yield but its share price may be in slow decline. We have seen this with Telstra shares, which have delivered a respectable dividend yield of 5.02%. However, faced with an intensely competitive market, the company's current share price of about $3.50 has fallen by about 19% over the past 12 months (which is pushing the yield up).
The upshot is that while Telstra investors have enjoyed a decent dividend yield, they may have lost out in the stock's capital value.
This highlights the downside of focusing on one particular company, or even a small handful of companies, as a source of passive income. Without diversification, you are intensifying the risk of your portfolio. And that risk could include a lower-than-expected dividend payment.
Broadly speaking, however, when a company pays fully franked dividends, the tax savings mean you can have less invested and still earn more after-tax than if you had the same amount of money in a savings account.
3. ETFs
One aspect of exchange traded funds (ETFs) that has seen Aussie investors flock to this type of investment is the instant diversity they offer for very low fees - a cost that can be lower than the brokerage associated with spreading your money across individual companies.
Better still, many ETFs pay quarterly distributions. This makes ETFs a more regular source of passive income than dividends, which are paid twice yearly at best.
How much passive income you will earn with an ETF depends on the fund you select and its underlying investments.
As a guide, over the past 12 months, the Vanguard Australian Shares High Yield ETF (ASX: VHY) has paid an annual yield of 5.33%. On that basis, investors would need to have around $188,000 invested in the ETF to achieve a passive income of $10,000.
Here too the after-tax income can vary depending on the ETF. Investors can receive franking credits attached to the shares held by the ETF, which can make this sort of investment very attractive to those looking for passive income. The thing to be mindful of is fund fees. Yes, they can cost less than brokerage to buy individual shares. But brokerage is a one-off cost (if you hang onto the stock) while fund fees are a recurring expense that you pay every year that you own units in the ETF.
How can I ramp up passive investment income?
Passive income is especially important when we are in retirement. Until then, a regular pay packet may mean you don't need passive income from your investments. If that's the case, it can make a lot of sense to reinvest returns and let compounding work its magic.
It's a strategy that can turbocharge the capital value of your investments, which in turn, will boost the passive income earned when the time comes that you need the money to live on.
Note: Interest rates, share and ETF values and yields are as at 5 June 2024.
