Here’s how I’d turn £5 a day into £7,678 of yearly passive income

The UK stock market includes dozens of dividend shares. And this cash-distributing variety offers an excellent way to earn regular passive income.

One day I’d like to replace some of my earnt income with one that I don’t need to work for. I know it won’t come immediately, but with a considered and long-term approach I’d expect to get there.

Magic of compounding

On average, FTSE 100 shares have managed to return 8% a year, including dividends. If it doesn’t sound like much, note that it can certainly add up in the long run.

That’s partly due to the magic of compounding. This mathematical marvel effectively means investors can earn dividends on their dividends. When repeated, it has the effect of amplifying gains over time.

But first, I’d need to find suitable stocks to own.

Shares I’d buy

To avoid putting all my eggs in one basket, I’d aim to own a basket of shares. That way, if one suffers a company-specific issue, the others can help to spread my risk.

One cost-effective idea is to buy a FTSE 100 index fund. This would be a simple option where I’d effectively own all 100 shares.

But as I like more control over what I own and a focus on passive income, my preference is to own a basket of carefully selected UK stocks.

If I had spare cash in my Stocks and Shares ISA to devote to a passive income strategy, I’d buy Phoenix Group, Legal & General, British American Tobacco, Rio Tinto and Aviva.

It’s important not to solely focus on dividend yield though. Although it’s important, it’s not the only factor to consider.

Earning reliable passive income

To decide if a company’s dividend is reliable, I’d look at a measure called dividend cover. This notes by how much the dividend is covered by its earnings.

The larger this number, the better. But generally, I’d consider shares that display 1.2 or greater. Note that my selected shares offer a dividend cover of 1.7 and an average yield of 8.6%. That sounds pretty good to me.

Note that there are some higher yields available in the FTSE 100. But I’d say a dividend yield over 10% might not be sustainable. And as payouts can be cut or suspended by management, opting for unsustainable dividends might not be wise.

Many factors can affect a business, so I’d need to monitor my stocks to ensure they continue to meet my criteria. But sources like The Motley Fool could help with that.

£7,678 a year

If I had £5 a day to devote to this strategy, that equates to £1,825 a year. With my basket of shares yielding 8.6%, the dividends would total £157.

As I alluded to earlier, I’d need a long-term approach to build a solid second income though. Of course, it’s not guaranteed and my investments could go down as well as up.

But I calculate that by continuing to make regular investments over 20 years, I should be able to grow my pot to around £90,000. And that should be enough to earn a neat £7,678 a year in passive income.