Building a passive income for retirement could be increasingly important in the years ahead. The State Pension will come under increased pressure as pensioner numbers boom. With living costs and social care bills also rising, taking steps now will become increasingly critical.

Recent research showed that we have roughly £500 left each month after bills and other outgoings. That, if invested in the stock market, could make a big second income in retirement achievable. An annual passive income above £39k is a real possibility.

Here are four key steps to consider to reach that goal.

1. Reduce tax

Capital gains and dividend taxes are a huge burden for share investors. Rule changes mean HMRC is taking an increasingly large slice out of investors’ profits too.

We can avoid these tax grabs by investing in a Stocks and Shares ISA, and/or a Self-Invested Personal Pension (SIPP). These savings can be invested into the stock market to boost the compounding effect. Speaking of which…

2. Reinvest any dividends

The compounding process can be turbocharged when individuals reinvest any dividends they receive. Over the long-term, this can make an enormous difference to a nest egg.

Investing platform AJ Bell has the data to back this up. It showed that £10,000 invested in the FTSE 100 in June 2015 could turn into £17,134 two decades later. That represents an annualised return of 2.7%.

With dividends reinvested, the end result would have been £38,079, more than double that earlier figure and representing an average yearly return of 6.7%.

3. Diversify for the win

Next, we need to talk about what to put your shares portfolio. Exactly what you’ll buy will depend on your personal circumstances, financial objectives and investing style, including risk tolerance. No two portfolios will be the same (unless you’re a copy trader).

But the most successful investors make sure their portfolios are well diversified to reduce risk and capture different growth and dividends opportunities. We’re talking about stocks spread across different regions, industries and sub-sectors.

An easy way to achieve this is with an exchange-traded fund (ETF) such as the iShares FTSE 250 ETF (LSE:MIDD). As the name suggests, this instrument spreads investors’ cash across hundreds of UK mid-cap companies and I think it’s worth a look.

An index tracker like this can deliver lower returns than individual shares can. You’re unlikely to see the value of your investment double or treble in a short space of time. But the long-term risk benefits and stability these funds provide can more than offset this.

Besides, ETFs can still deliver an excellent return over time. The iShares FTSE 250 fund’s delivered an average annual return of 9.4% since its creation in 2004.

4. Making passive income from dividends

A well-diversified portfolio of individual stocks, funds and trusts has a great chance of achieving an average annual return of 9%. At this rate, a £500 monthly investment would after 30 years turn into £560,561.

There are plenty of ways to turn this into a regular second income. My own plan with my own portfolio is to rotate into high-yield dividend shares to fund my retirement.

This way, I can target ongoing portfolio growth along with regular dividends. If I were to have £560,561 put into 7%-yielding shares, I could earn a £39,239 annual passive income.

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Royston Wild does not hold any positions in the companies mentioned.