How $250 per Month Can Create $50,000 in Annual Dividend Income

Building a steady stream of income from your savings is a big goal for many investors. If you could fully replace your paycheck with dividends, you could easily retire and even expect to receive annual raises for the rest of your life. And the best part is you wouldn't even have to sell your stocks. You could pass on your holdings to your heirs, gifting them a steady stream of dividends over their lives too.

While $50,000 in annual dividend income may sound like a dream, it's actually well within reach for many investors. And it doesn't require risky bets on ultra-high-yield dividend stocks with precarious payouts. You can get there with just a couple of simple index funds.

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Step 1: Build a big nest egg

While you're in the accumulation phase, your goal is to grow your portfolio as much as possible.

One of the most effective ways to build a sizable portfolio is by investing in an S&P 500 index fund such as the Vanguard S&P 500 ETF (VOO 1.00%). The ETF tracks the performance of the S&P 500 index, which includes 500 of the largest profitable U.S. companies.

One of the things that makes an S&P 500 index fund so effective as an investment vehicle is the requirements of the index. It only includes companies that have reported positive earnings for the last four quarters. From that pool of possible investments, it caps the number of possible constituents to 500.

For the committee in charge of constructing the index to add a new stock, they must remove a stock first. As a result, a company in which investors are showing higher conviction (seen through a growing market cap) will replace a company in which investors are losing conviction (seen through a diminishing market cap).

Over the long run, the S&P 500 index has produced very strong returns for investors. When reinvesting dividends, the index has produced a compound annual total return of 9.7% since 1928. Over the last 15 years, returns have been an even stronger 13.8%.

Here's what investing just $250 per month in an S&P 500 index fund could look like over time, assuming a 10% annual return.

Data source: Author. Calculations by Author.

These are simply hypothetical numbers. There's no guarantee the next 40 years will see the S&P 500 return anywhere near the average of the last 96 years. And you won't see the index climb the same amount every month -- the stock market is inherently volatile.

But this long-term strategy remains one of the most dependable ways to build a nest egg worth over $1 million. And once you top that threshold, you can move on to step two.

Step 2: Turn your portfolio into a paycheck

Once you've built a sizable portfolio, you'll need to find a way to start producing significant dividend payments.

Again, index funds can be a great option for diversification and simplicity. One of the best ways to put together a high-yield portfolio is by trading your S&P 500 index fund for a high-yield index fund like the SPDR Portfolio S&P 500 High Dividend ETF (SPYD -0.15%).

This ETF tracks the performance of the top 80 highest dividend-yielding companies on the S&P 500 index. It currently offers a yield of 4.98% with an expense ratio of 0.07%. That means you could generate close to $50,000 in annual income after fees by investing a $1 million in the ETF.

There are some important caveats, though. The index might not yield as much in the future -- the average since inception has been about 4.2%. However, with its focus on just the 80 highest-yielding stocks in the S&P 500, this fund can offer market-beating dividends long term.

Another important caveat is that selling shares of your S&P 500 index fund to buy shares of the High Dividend ETF could result in a hefty tax bill. If you're investing outside of your retirement accounts, you'll need to keep in mind any capital gains taxes you'll owe when selling shares. That could reduce the amount you're actually able to invest in the high-dividend ETF.

Regardless, any amount you invest in the SPDR S&P 500 High Dividend ETF should produce a nice stream of growing income, and you won't have to touch your principal investment. That makes it a great way to generate income from a portfolio of any size, whether it's a few thousand dollars or over $1 million.