Passive Income – How To Put Your Money To Work – Forbes Advisor UK

The current cost of living crisis is encouraging people to find additional sources of income to cover rising food, petrol and energy bills. So-called ‘passive’ income can be a good way of supplementing your household earnings to provide a safety buffer when finances are tight.

Fortunately, there’s a growing number of passive income options, with the pandemic opening up innovative ways to earn much-needed extra money. Let’s take a closer look at how you could earn a passive income.

What is a passive income?

Passive income refers to income that does not need a significant commitment of time or money. Although most passive income ideas require some initial time, money or resources, they should require only minimal monitoring on an ongoing basis.

There are three main types of passive income streams:

• Investing: generating a return from investing money in saving accounts or the stock market.
• Asset sharing: selling or renting out assets you own, such as your house or car.
• Asset building: examples could include adding revenue-generating affiliate links to your blog or website or selling resources such as ebooks, educational content, music and photos online. 

While all these categories have the potential to generate a substantial income, here’s some of our top suggestions for earning a passive income in the UK.

Best passive income ideas

Dividends from investments

Dividends are paid by companies to their shareholders and can provide a good passive income stream if you have available funds to invest. However, they are not guaranteed and many companies temporarily suspended their dividend payments during the pandemic. 

The dividend yield is a good indicator of the ‘return’ on your investment, similar to the annual rate on a savings account. It is calculated as the dividend payment divided by the price of the share (or investment). So if a company with a share price of £100 pays an annual dividend of £4, its dividend yield would be 4%.

There are three main ways to earn a dividend stream from investments, all of which can be held in a Stocks & Shares Individual Savings Account without incurring any income tax.

a. Company shares

Some, but not all, companies pay dividends to shareholders. Dividends are typically paid in cash on a quarterly or half-yearly basis. Companies may also pay ‘special’ one-off dividends to return cash to shareholders, for example, after the sale of a business.

Global dividends surged to a record high of £1.2 trillion in 2021, according to investment house Janus Henderson, driven partly by the boom in dividends paid by mining companies. 

However, there can be a trade-off between dividend pay-outs and share price growth. ‘Growth’ shares such as Tesla, Amazon and Meta have not historically paid dividends, preferring to invest surplus cash to generate future growth.

By comparison, the more traditional, ‘blue chip’ companies tend to pay higher dividends. Investors’ Chronicle reports that the average dividend yield for the FTSE 100 and the Nasdaq is currently 3.3% and 0.7% respectively. 

This illustrates the higher proportion of dividend-paying, industrial companies in the FTSE 100 compared to the technology-heavy Nasdaq.

However, caution should be taken over instances of very high dividend-yielding shares, which can occur when there’s a sharp fall in share price, artificially inflating the dividend yield. This means fundamentals other than dividend yield should also be considered when researching whether to buy shares in a company.

b. Investment trusts

Investment trusts invest in assets such as shares, and the majority of trusts pay dividends to investors. As with shares, investment trusts have a ‘live’ trading price which can go up or down depending on demand.

The benefit of investment trusts (over funds – see below) is that they’re allowed to retain 15% of annual income to build a ‘rainy day’ cash reserve, enabling them to maintain consistent dividend payments in market downturns. 

According to the latest Association of Investment Companies’ list of ‘dividend heroes’, seven investment trusts have increased their dividends for more than 50 consecutive years. 

As with shares, dividend yields should be considered alongside other factors if you’re looking to buy an investment trust, particularly its future prospects for share price growth. There is a variety of investment trusts from which to choose, including specialist equity income trusts and trusts focused on different sectors such as technology, property and commodities, along with different geographic regions.

c. Funds

Funds are similar to investment trusts in that they hold an actively-managed portfolio of shares and other assets. However, they don’t have a ‘live’ price and are re-priced once a day based on the value of their underlying assets

Although many funds pay an income in addition to capital growth, funds whose primary purpose is to pay an income are found in the UK and Global Equity Income categories. According to investment information provider Trustnet, most UK Equity Income funds currently pay a dividend yield of between 3% to 5%.

When buying funds, you may be offered a choice of income or accumulation units. Income units pay dividends in cash to investors. With accumulation units, dividends are used to buy additional units in the fund, providing the opportunity for future capital growth by reinvesting dividends.

Interest from savings accounts and bonds

a) Company shares

Lodging your money in a savings account also produces a passive income. Easy-access savings accounts are currently paying up to 1.2%, while the leading regular saving accounts offer rates of up to 2.0%, although these typically have a monthly limit of £100 to £500.

It is worth reviewing the interest rate on a regular basis as it may include a limited-period bonus rate. In addition, banks may not pass on any increase in the Bank of England base rate in full to customers with variable-interest rate accounts.

You should also check that your account is covered by the Financial Services Compensation Scheme, which protects customers up to £85,000 in the event of the failure of a bank or building society.

Although investing in savings accounts is lower-risk than the stock market, the average return has also historically been lower. Given the current inflation rate of 7%, money invested in savings accounts paying an interest rate of 1% will be effectively losing 6% in real terms each year. 

b) Fixed-rate bonds

Fixed-rate bonds are another option if you’re willing to tie up your money for a longer period. Some of the leading fixed-rate bonds offered by banks and building societies are paying up to 2.4% for a two-year fixed rate or 2.6% for a five-year fixed rate.

c) Premium bonds

Premium bonds are a type of savings product from National Savings & Investments (NS&I), held by over 21 million people in the UK. Instead of paying interest, premium bonds offer bond-holders the opportunity to win prizes ranging from £25 to £1 million each month tax-free. You can withdraw your money at any time by cashing all, or some, of your bonds.

According to the NS&I, there is a 34,500 to one odds of winning a prize per £1 bond, equivalent to a 1.0% interest rate. This rate is currently just below the leading easy-access savings accounts, although there is no guarantee that you will win a prize. 

Income from property

Investing in property can generate a substantial passive income, either from long-term rental or short-term holiday lets. However, this involves a significant up-front investment, as well as ongoing maintenance and management of the property. 

Landlords have faced an increasingly challenging environment in the UK, with the end of tax-relief on mortgage interest in 2020, rising interest rates and the recent requirement for minimum Energy Performance Certificate ratings for rental properties.

Property yield is used as a rule-of-thumb measure for estimating the annual return from property, and is calculated as the annual rent divided by the purchase price. According to property developer SevenCapital, the average rental yield in the UK is 3.6% (as of April 2022). 

However, yield varies by region with SevenCapital reporting that average property yields in 2021 ranged from 2.9% in London to 4.4% in the North-West. While holiday lets may offer higher potential yields, this is dependent on how many weeks a year the property is rented for and the additional management fees.

In summary, the income yield from property is low, given that costs such as mortgage interest and maintenance need to be deducted from rental income. However, rental property can also provide capital upside over a longer-term period.

Final thoughts

Although substantial capital is required to invest in property, it is possible to generate a passive income from investing small amounts of money into savings accounts and equity investments. 

As with any investment, you should consider the level of risk associated with the product and whether you are able to absorb any losses. In most cases, income tax will be payable on passive income, unless you hold investments in a tax-efficient wrapper such as an ISA.