Premium bonds or dividend shares – which is my better bet for passive income?

It’s tough to know where to invest your money for passive income these days. Interest rates remain low, while stock markets continue on a roller-coaster ride with no sign of slowing down any time soon.

Premium bonds and dividend shares offer two very different ways for me to create additional passive income.

But which one is best for me when deciding where to invest my hard-earned cash?

Cash is no longer king

One thing I do know, cash is no longer a viable option for me. With inflation continuing to run riot, the idea of a negative return rate is not something I really want.

So, what are my options?

Can premium bonds have a place in my portfolio?

Premium bonds are a popular option here in the UK. Backed by the government, they’re a very low-risk option with a fun element to them. I mean, who doesn’t dream of getting an instant millionaire phone call each month?!

But that safety comes at a hefty price on expected returns.

Yes, the more bonds I own, the greater my chance of winning. But even with £40k invested, my average expected ‘prize rate’ works out to an approximate 0.9% annual return. Or about £350, in actual money terms.

It may well have the advantage of being tax-free, but it’s still well under the 1.5% return of the best-paying cash savings account available.

So, am I feeling especially lucky? Well, personally, I prefer to go with the numbers.

Are dividend shares my answer for passive income?

Dividend shares look a far more attractive option for my passive income portfolio. With my focus on reliability, I’m not interested in chasing the highest yield available. But, there are still numerous options available around the 5% yield in the FTSE 350.

For example, I could be tempted by Royal Mail (LSE: RMG). Down over 30% year to date, it’s looking better value and now offering around a 4.7% dividend yield, excluding the one-off special payment this year.

If I invested my £40k here instead, I’m now looking at generating about £1,880 in dividend payments. That’s over £1.5k more than that median premium bond win expected!

If this were my only dividend income this tax year, then handily, it’s still tax-free by virtue of the £2,000 tax-free dividend allowance available in 2022/23. Otherwise I’d need to use my Stocks & Shares ISA allowance to keep it tax free.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

Can I handle the risk?

With stock market volatility, dividend shares are a riskier strategy than premium bonds. I need to be prepared to stay invested for around five years. That way, I can look to hopefully take advantage of the long-term average trend of positive market returns.

But I also need to remember that dividends are not guaranteed and can be reduced or cut all together. As such, I would also really want to split that £40k across a few different dividend shares to create a diversified portfolio. That way, if Royal Mail does cut its dividend, it has less of an impact on my overall portfolio performance.

By investing for the long term, I’m comfortable with these risks and approach. I can leave my capital invested and let my chosen dividend shares hopefully provide a healthy passive income for me over that time.

After all, I’d rather see those dividend payments coming in regularly than wait hopefully by the phone each month!