2 Vanguard index funds could turn $400 a month into $16,800 in annual dividend income in retirement

The S&P 500 (^GSPC -0.29%) it has outperformed virtually all other asset classes over the past decade, including bonds, international stocks, precious metals and real estate. The index also outperformed more than 85% of large-cap funds, meaning S&P 500 index funds often produce better returns than professional money managers.

Investors can use this information to build a portfolio that generates large amounts of passive income. For example, $400 invested monthly in an S&P 500 index fund could grow to $789,500 over three decades. That amount could then be reinvested (less capital gains tax) in a high dividend yield index fund to generate passive income of $16,800 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 (VOO -0.33%) is a low-cost S&P 500 index fund. It measures the performance of 500 US companies covering approximately 80% of domestic stocks and more than 50% of global stocks by market capitalization. In other words, it allows investors to spread capital across many of the world’s most influential businesses.

The five largest holdings in the Vanguard S&P 500 ETF are listed below by weight:

1. Apple: 6.9%
2. Microsoft: 6.5%
3. Nvidia: 6.2%
4. Alphabet: 3.7%
5. Amazon: 3.4%

The S&P 500 has returned 2,000% over the past 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 type of account, investors may have to pay capital gains tax when they sell the Vanguard S&P 500 ETF. Federal taxes on that amount would total about $100,000, but state taxes would vary. So I’ll round up 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 ETF Vanguard High Dividend Yield (VYM -0.25%) measures the performance of 550 US companies predicted to pay above-average dividends. While 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 below by weight:

1. Broadcom: 4.2%
2. JPMorgan Chase: 3.6%
3. ExxonMobil: 3%
4. Procter & Gamble: 2.3%
5. Johnson & Johnson: 2.2%

The Vanguard High Dividend Yield ETF currently pays a dividend yield of 2.63%. At this rate, the $639,500 in the previous section would generate about $16,800 in annual dividend income. And the pay should increase over time.

The Vanguard High Dividend Yield ETF has returned 88% over the past decade. At that rate, the total amount invested in the index fund would reach $1.2 million over 10 years, and that total would generate annual dividend income of about $31,600.

Most people should save more than $400 per month

The average American worker earned $69,240 in after-tax income in 2023, according to the Census Bureau. Financial planners generally recommend saving 20% ​​of your after-tax income for retirement. That means the average worker would need to save $13,848 per year or $1,154 per month.

In this context, $400 per month is a reasonable goal for most people. It would also leave the average worker with $754 a 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 figures of passive income annually until retirement.