£5,000 in savings? I’d aim for £17,200 a year in passive income

I think it’s smart to have some money tucked away in a savings account for a rainy day. But leaving cash in the bank isn’t the most effective way to get it working as hard as possible and generating passive income.

High interest rates have seen banks offer attractive savings rates over the last few years. But if I wanted to start making some extra cash I’d do it by buying dividend shares.

I see it as one of the simplest and most effective ways to build wealth. With £5,000, here’s how I’d aim to turn that into a significantly higher second income.

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Firstly, I’d use an investment tool like a Stocks and Shares ISA. Every year investors are given a £20,000 limit to use. So, even after investing my £5,000, I’d still have plenty of my allowance left to invest more. Through a Stocks and Shares ISA, with the profits I make I don’t have to pay any tax.

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Secondly, I’d target stable businesses with yields of over 6%. To do that, I’d turn to the FTSE 100 and FTSE 250. They’re home to many household names in the UK that have proven and stable business models.

How I’d get there

To achieve my goals, it’s stocks like M&G (LSE: MNG) that I’d target. Despite the Footsie going on a surge, the investment manager has struggled this year. So far, its stock is down 10%.

But with its cheaper share price comes a higher yield. Right now, the stock boasts a 9.8% payout, the fourth highest on the index.

Of course, dividends are never guaranteed. That said, M&G has a track record of increasing its dividend. It has upped its payout every year since it listed in 2019. Management’s aim is to increase its dividend every year going forward.

Furthermore, M&G is a stable business with a vast customer base. Those are the sorts of companies I tend to invest in. Last year, its adjusted operating profit rose 28% year on year to £797m.

The risk is that it experiences customers pulling money from funds in the months to come as economic uncertainty continues. We saw this occur last year.

But it’s a stock I think investors should consider today. Trading on 8.8 times forward earnings, its shares looks cheap. That’s cheaper than the Footsie average of 11. With interest rate cuts expected later this year, that could also provide the stock with a boost going forward.

Targeting a passive income

With that in mind, I now need to try and turn my £5,000 lump sum into a recurring second income. Taking M&G’s 9.8% yield and applying it to my amount would earn me £440 a year in passive income. I’d like to make more than that.

To achieve that, I’d reinvest my dividends. That would allow me to benefit from compounding, essentially meaning I’d earn interest on my interest. Furthermore, I’d add a £100 monthly contribution. There are many benefits to investing on a regular basis.

Compounding at 9.8%, after 25 years, my £5,000 would generate £17,200 a year in interest. That would set me up for a much more comfortable retirement.