My preferred way to earn a second income in my ISA is by investing in dividend shares. Many UK-listed companies distribute a portion of their profits to shareholders in the form of regular cash payments called dividends.
Some shares currently offer yields as high as 10% a year. That means if I buy £10,000 of these stocks, I could receive around £1,000 a year in passive income.
That might sound appealing, but a word of warning. This enticing yield might not be sustainable. Dividends aren’t guaranteed and companies can choose to suspend or cut them.
If that were to happen, it could dramatically cut my second income.
What I’d consider
Importantly, there’s more to consider than just the dividend yield. Investors should also look at how reliable shares are at consistently paying dividends.
One way I do so is by looking at a company’s payout history. If it’s managed to pay regular cash to shareholders over several years, that gives me added confidence it could continue over the coming years.
Next, I’d consider its dividend growth potential. As a business grows its earnings, there’s a possibility management will also raise dividend payments. Over time, these additional payments can add up and significantly boost dividend income.
How to invest £20k
To earn a second income within my first year of investing, I’d buy a selection of the best dividend stocks.
The large-cap FTSE 100 includes many high-yielding and high-quality dividend shares, but I’d also consider stocks from the mid-cap FTSE 250 index.
Along with diversifying by size, it’s worth spreading my choices across different industries. That would avoid putting all my eggs in one basket.
Diversification across several shares is important. If one stock or sector was hit with poor performance, spreading my risk could reduce the impact on my overall portfolio.
That said, I also wouldn’t buy loads of different stocks. Remember there are transaction costs to consider too. Many investment platforms will charge dealing charges for a purchase and sale. Stamp duty on shares may also be applicable.
For a £20,000 Stocks and Shares ISA, I’d select around five or six top picks.
Building my second income
If I had £20,000 to allocate to building a reliable second income right now, I’d buy the following dividend shares.
First, Phoenix Group Holdings. This retirement business offers a whopping 9.2% yield. Despite my warning earlier, this one is well covered by stable earnings.
It has 14 years of back-to-back payment history and has also been growing its dividend for the past seven years. Bear in mind that, historically, it has achieved little capital growth. But it sure looks like a solid dividend stock.
British American Tobacco, Legal & General, Rio Tinto and IG Group also offer excellent dividend prospects, in my opinion. They’re also sufficiently diversified across several sectors. On average, these five shares offer a 7.8% dividend yield and 20 years of consecutive payout history.
That’s enough to earn a juicy £1,560 in annual passive income.
