The S&P 500 (SNPINDEX: ^GSPC) outperformed virtually every other asset classes over the last decade, including bonds, international stocks, precious metals, and real estate. The index also outperformed over 85% of large-cap funds, meaning S&P 500 index funds often produce better returns than professional money managers.
Investors can use that information to build a portfolio that generates large amounts of passive income. For instance, $400 invested monthly in an S&P 500 index fund could grow into $789,500 over three decades. That sum could then be reinvested (less capital gains tax) in a high dividend yield index fund to generate $16,800 in passive income annually.
Here are the important details.
Step 1: Invest $400 per month in the Vanguard S&P 500 ETF
The Vanguard S&P 500 ETF (NYSEMKT: VOO) is a low-cost S&P 500 index fund. It measures the performance of 500 U.S. companies that cover approximately 80% of domestic equities and more than 50% of global equities by market capitalization. In other words, it lets investors spread capital across many of the most influential businesses in the world.
The five largest holdings in the Vanguard S&P 500 ETF are listed by weight below:
Apple: 6.9%
Microsoft: 6.5%
Nvidia: 6.2%
Alphabet: 3.7%
Amazon: 3.4%
The S&P 500 returned 2,000% during the last three decades, which equates to 10.6% annually. I'll round down to 10% to introduce a margin of safety. At that rate of return, $400 invested monthly in the Vanguard S&P 500 ETF would be worth $789,500 after three decades. Investors can then sell the index fund and reinvest the proceeds in another fund.
Depending on the account type, investors may have to pay capital gains tax when they sell the Vanguard S&P 500 ETF. The federal taxes on that amount would total about $100,000, but the state taxes would vary. So, I'll round the total tax burden to $150,000, which leaves $639,500 to reinvest in another index fund with a high dividend yield.
Step 2: Invest $639,500 in the Vanguard High Dividend Yield ETF
The Vanguard High Dividend Yield ETF (NYSEMKT: VYM) measures the performance of 550 U.S. companies that are forecasted to pay above-average dividends. Whereas the Vanguard S&P 500 ETF includes value stocks and growth stocks, this index fund leans heavily toward value stocks. The five largest holdings are listed by weight below:
Broadcom: 4.2%
JPMorgan Chase: 3.6%
ExxonMobil: 3%
Procter & Gamble: 2.3%
Johnson & Johnson: 2.2%
The Vanguard High Dividend Yield ETF currently pays a dividend yield of 2.63%. At that rate, the $639,500 from the previous section would generate about $16,800 in annual dividend income. And the payout should increase over time.
The Vanguard High Dividend Yield ETF returned 88% over the last decade. At that pace, the total amount invested in the index fund would reach $1.2 million in 10 years, and that total would generate about $31,600 in annual dividend income.
Most people should save more than $400 per month
The median American worker earned $69,240 in after-tax income in 2023, according to the Census Bureau. Financial planners generally recommend saving 20% of after-tax income for retirement. That means the median worker should be saving $13,848 per year, or $1,154 per month.
In that context, $400 per month is a reasonable goal for most people. It would also leave the median worker with $754 per month in additional savings, which could be invested in stocks or other index funds. Either way, the end result should be a sizable nest egg that pays five digits of passive income annually by retirement.
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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Trevor Jennewine has positions in Amazon, Nvidia, and Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, JPMorgan Chase, Microsoft, Nvidia, Vanguard S&P 500 ETF, and Vanguard Whitehall Funds-Vanguard High Dividend Yield ETF. The Motley Fool recommends Broadcom and Johnson & Johnson and recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.
2 Vanguard Index Funds Could Turn $400 Per Month Into $16,800 in Annual Dividend Income by Retirement was originally published by The Motley Fool