£20,000 in savings? Here’s how you can use that to target a £5,755 yearly second income

Let’s say I wanted to use dividend stocks to turn £20,000 in savings into a £5,000 yearly second income or more. Such a target would require a reliable 25% return year after year.

Across the thousands of stocks across the London Stock Exchange, not one pays a dividend yield close to that figure. I should just pack my things and go home, shouldn’t I? Or should I?

Snowball effect

While it’s true that the highest dividends across the FTSE 100 and FTSE 250 pay up to 13% or so – and rare for any stock to pay more than 9% for long periods – this is turning a blind eye to the benefits of excellent stock selection.

The very best dividend stocks don’t just pay out the same chunk of change year after year. The payouts are slowly increasing, creating a powerful snowball effect. There are dozens of stocks that have shelled out more every single year for a quarter of a century!

This ramping up of payments over time lets the effects of compound interest run riot. And we can pair the bumps to the dividend with reinvesting the amounts we receive to multiply the effects even further.

A stock that pays a dividend yield of 8% per year with a 5% annual growth rate is more than enough to make impressive amounts. What does this look like in practice?

By the 10-year mark, the effective yield on the original stake is 28.78%. That would mean a £20k up front payment would return approximately £5,755 in the tenth year.

Strategy

This strategy hinges on finding the right firm to invest in, which is why I’m always on the hunt for the cream of the crop in dividend stocks. Looking at the big payers on the FTSE 100 at present, I’d say Legal & General (LSE: LGEN) could fit the bill.

This is a company with a well-covered dividend that has stayed in the 8%-9% range for years. Although dividends are never guaranteed, current forecasts suggest no imminent threats to future payments.

Most crucially, the firm has a rock-solid track record of dividend increases. The 10-year average growth rate is 6.17%. Remember, it’s the growth in dividends along with reinvesting that is really going to supercharge the future earnings.

As an insurance and investments group, Legal & General may struggle in tough economic conditions. Pandemic jitters led to no rise in the dividend in 2020, for instance. The threat of COVID was only temporary for the FTSE 100 stock but we can never rule out an even bigger crisis being around the corner.

All being said? I think Legal & General fits the mould of a world-class dividend stock. I’d say it’s worth considering for a portfolio geared towards a large second income.