How to make $12,000 of passive income a year

MotleyFool
07-04

Passive income is one of the most powerful financial goals you can aim for.

And while the idea of earning $1,000 per month without lifting a finger might sound far-fetched, the maths — and the market — suggest otherwise.

In fact, with a realistic long-term plan and the right approach to ASX share investing, it is entirely within reach.

$12,000 of passive income a year

Let's start with the goal. If you want $12,000 a year in passive income from dividends, you're going to need a sizeable investment portfolio.

It is relatively easy to build a passive income portfolio with an average 5% dividend yield. With this sort of yield, you would need an investment portfolio valued at $240,000 to generate the desired income.

That may sound like a big number — and it is — but it doesn't need to be built overnight.

Don't chase income too early

Investors often fall into the trap of chasing income from the get-go. But when your portfolio is small, it is far better to leave your funds to compound than take anything out.

For example, a 5% yield on a $5,000 investment only gets you $250 per year. That is hardly enough to move the needle.

The smarter strategy — especially early on — is to prioritise capital growth. High-quality ASX growth shares, such as Xero Ltd (ASX: XRO) or WiseTech Global Ltd (ASX: WTC), may not pay big dividends, but their long-term compounding potential can help your portfolio reach critical mass faster.

Once you're closer to your income goal, you can switch gears.

Transition to income

Once you reach $240,000, you can start to think about passive income.

It is hard to say which ASX dividend shares will be buys at that point, but if it were today, you might look at shares such as Telstra Group Ltd (ASX: TLS), BHP Group Ltd (ASX: BHP), or simply the Vanguard Australian Shares High Yield ETF (ASX: VHY).

The main thing to remember is to look for an average dividend yield of 5% across a diversified portfolio. You don't want all your eggs in one basket.

How long will it take?

How long this endeavour takes is largely dependent on how much you can invest and how the share market moves.

Historically, the Australian share market has on average generated a 10% per annum total return.

If it were to do the same again, it would take a little over 16 years to reach $240,000 if you were able to invest $500 into ASX shares each month.

Alternatively, if you could afford to invest $1,000 each month, you would reach your destination after a touch over 11 years, all else equal.

Foolish takeaway

Generating passive income from ASX shares is very achievable for investors that have a combination of patience, capital, and time. And by following the steps above, you could potentially get to $12,000 a year sooner than you might have thought.

The key is to come up with a plan that fits your budget and then stick with it through thick and thin.

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