How I’d invest my £20k ISA allowance to earn a second income of £1,632 a year

Now looks like a terrific time to generate a second income from investing in FTSE 100 dividend stocks, tax-free in an ISA.

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Investing in an ISA is a brilliant way to generate a second income because it will be completely free of tax for life.

If I invest in a Stocks and Shares ISA, I won’t have to pay a penny in capital gains tax (CGT) on my share price growth. All the company dividends I receive are free of income tax too.

That’s more important than ever, now that Chancellor Jeremy Hunt has slashed the annual CGT threshold to just £6,000 and halved the dividend allowance to £500, for stocks held outside the ISA wrapper.

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.

I’m hungry for dividends

I’m looking to generate maximum income by investing in high-yielding FTSE 100 shares. I’ll reinvest all my shareholder payouts straight back into my portfolio today. When I retire, I’ll draw them as income.

The FTSE 100 has recovered nicely since the banking crisis, but I can still find plenty of top dividend stocks trading at cheap valuations.

Every UK adult has just been handed a new £20,000 ISA allowance, for the 2023/24 tax year. Most of us won’t be able to invest the full amount, but I’m still going to invest as much as I can.

I’ve just counted 18 FTSE 100 stocks yielding 5% or more. Of these, 12 yield at least 7% or more, giving me scope to build an impressive second income.

I always approach high-yielding stocks with caution. They can be a sign of a company in trouble, as a falling share price drives up the yield. Sky-high dividends can quickly become unsustainable. 

Last autumn, for example, housebuilder Persimmon and mining giant Rio Tinto yielded around 20% and 10% respectively. Both have since slashed their shareholder payouts.

My yield target is 7% or more

I’d like my second income to be sustainable and would get my income stock picks down to five at the safer end of the scale.

Housebuilder Taylor Wimpey yields 8.17%, Rio Tinto yields 7.46%, insurer Aviva yields 7.43%, Imperial Brands yields 7.42% and asset manager M&G yields 10.31%.

These five companies combined offer an average yield of 8.16%. If I split my £20,000 ISA contribution limit evenly between them, investing £4,000 in each, I’d generate income of £1,632 in the first year. That’s £136 a month.

Naturally, there are risks. Taylor Wimpey could suffer if house prices crash. Rio Tinto has just cut its dividend (although this may argue against another cut). M&G’s double-digit yield looks particularly suspect, but management expects to generate £2.5bn of cash this year. If it does, the payout should hold. I’ll reduce the dangers by doing my research and investing for the long term.

If all goes well, my income should rise over time, as these companies increase profits and boost their dividends over time. Even if one or two are cut, I should still generate a pretty healthy level of income. I feel the rewards far outweigh the risks.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Harvey Jones has positions in M&g Plc, Persimmon Plc, and Rio Tinto Group. The Motley Fool UK has recommended Imperial Brands Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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