The new Stocks and Shares ISA year is underway, allowing investors to park £20k there over the next 12 months. The benefits of investing via an ISA are numerous, including the ability to avoid capital gains and dividend tax when selling a stock or getting income.
As a result, an ISA can be a great source to build up high levels of passive income further down the line. Here’s how to nail it.
Starting by working backwards
To reach a target of £10k of annual passive income, I need to work backwards. What does the total ISA pot need to be in order to reasonably expect to generate this kind of cash?
It all hinges on the average dividend yield I can get from the market. At the moment, the FTSE 100 average yield is 3.55%. But if I discount some stocks that don’t pay any income at the moment, and tilt to a more active portfolio, I can increase this to 5-7%.
Let’s take 6% as a figure for my forecasts. Using this number, an investor would need to have an ISA with a value of £166.6k. In the following year, they could expect to earn a 6% yield in income, totalling £10k.
Maximising investment potential
Now that we know the number we’re aiming for, it’s easier to work towards it. The first element to focus on is growing the dividend portfolio to a value of £166.6k. Given the contribution limit of £20k a year, it’s obviously going to take several years to reach this goal, even if the allowance is used up fully each time.
To help speed up the process, investors can reinvest the dividend income received in the early years. This allows the money to compound. For example, if I have £1,000 in a stock that pays me £60 in income, I can reinvest and have £1,060 in the company. The following year, I should earn £63.60. Over time, this can make a large difference, although I have to accept that dividends aren’t guaranteed and could be cut.
Being smart in dividend stock picks
The second element is how to yield 6% each year. This is hard, because dividends aren’t guaranteed. If a business has a bad year, there might be no income to pay out from earnings. This is a key risk to this overall idea.
Investors can try and minimise the impact of this. A good way is to diversify holdings, to include a dozen or more stocks within the ISA. Another way is to look at the track record over the past decade of income payments from a particular company. Although this doesn’t predict the future perfectly, it gives me a good indication of sustainability.
Goals for the future, starting now
An ISA is a great investment tool for the retail market. Over the space of a decade, it’s entirely reasonable to have the goal of reaching a stage to enjoy £10k in passive income.
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.
