A Stocks and Shares ISA is a terrific way to generate passive income in retirement, because it means I can take it entirely free of income tax. Given that my pension income is taxable, that will limit my overall liability to HMRC.
Another big advantage is that there is no capital gains tax to pay on share price growth, so the capital value of my portfolio can grow tax-free too. If I need to make withdrawals to top up my income, again, no tax to pay.
I’m planning ahead today
I’m building a retirement income portfolio of FTSE 100 stocks, which offer some of the most generous dividends in the world. Today, the index as a whole yields 4% a year, while a select band of Dividend Aristocrats yield 7%, or more.
While I’m working, I will reinvest all the dividends I receive back into my portfolio for growth. I only plan to start taking them as income after I have retired.
Let’s say I was 30 years old with no savings to my name, and decided to play catch-up by investing £500 a month in a selection of FTSE 100 stocks. That works out at £6,000 a year, which is well inside today’s annual £20,000 ISA limit.
If I increased that by 3% a year, to keep pace with inflation, and stuck with it until I was 65, I would have a staggering £1.26m. This assumes my portfolio grows at an annualised rate of 7% a year, which is the average long-term return on the FTSE 100.
Now let’s say I assembled a portfolio of a dozen stocks that yielded slightly more than the FTSE 100 average, say 5% a year. If I drew all of my dividends, I would generate income of £63,000 a year!
That’s a pretty impressive £5,250 a month. Unfortunately, that won’t be quite as lucrative as it looks, because inflation will have eroded its value. But it’s still a pretty decent reward for 35 years of steady investing.
Best to invest for decades
If I didn’t start investing £500 a month until I was 40, I’d end up with half as much by age 65. Or to be precise, £535,052. Again, this assumes I increase my payments by 3% a year, and my portfolio delivers an average annualised return of 7%.
If my portfolio also generated a dividend yield of 5%, my annual income would still be £26,753, or £2,229 a month. Still well worth having.
My plan is not entirely foolproof. Dividends are not guaranteed, as we saw in the pandemic, and may be slashed if one of my stock picks runs into financial difficulties.
Buying individual stocks is always a bit risky, as one or two companies could perform poorly for years or, in the worst-case scenario, go bust. I would invest in at least 12-15 different companies, operating in different sectors, to limit the downside if that happens.
As my crude calculations show, by saving hard and lasting the course, I can look forward to a comfortable, tax-efficient retirement.
