Forget a Cash ISA! I’d invest £20k in the stock market for superior passive income

Our writer explains why he prefers to invest his £20,000 annual allowance in a Stocks and Shares ISA for passive income, rather than a cash one.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

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Earning passive income is one of my top investment goals. To achieve that objective, I need to ensure my money is working hard while I sleep.

In that regard, tax optimisation is important for me to maximise my passive income streams. The arrival of a new tax year means I can contribute £20,000 in an ISA, thereby sheltering my savings from HMRC’s clutches.

Although Cash ISA interest rates have soared, I’m ignoring them as things stand. Instead, I’d invest my £20k allowance in a Stocks and Shares ISA in pursuit of a bigger passive income haul. Here’s why.

Stocks for the long run

Deciding what to do with hard-earned money isn’t easy. Investing in the stock market can be daunting and it’s undeniably safer to keep money in cash savings.

However, with the top Cash ISA currently offering an interest rate of 4.31%, there’s a significant risk my savings would shrink in real terms if I choose this option. That’s because the annual inflation rate remains stubbornly high at 10.1%.

I subscribe to the view that the stock market is a good place to invest money with a long-term horizon. Equities have historically offered inflation-beating returns over substantial time periods.

Although past performance doesn’t guarantee future results, I’d prefer to assume some volatility risk by investing in shares rather than settle for mediocre returns on cash.

Dividend shares

Not all stocks are equal when it comes to passive income. Indeed, many companies don’t pay dividends, so investors rely on share price appreciation alone for returns.

Therefore, if I want to earn a second income from stocks without having to sell them, I’ll need to buy dividend shares that will hopefully also rise in price. Fortunately, there are plenty in the FTSE 100 and FTSE 250.

Currently, the FTSE 100 index offers an average dividend yield of 3.55%. As I’d exclusively focus on income-producing shares, I’d target a slightly higher 4% yield on my portfolio.

To illustrate the point, let’s imagine the Stocks and Shares ISA allowance remains unchanged, so I could contribute £20k annually starting in 2023/24.

Assuming a 7% return on my investments (combining 3% capital growth with a 4% dividend yield), if I contributed the maximum amount each year and reinvested my payouts into more stocks, here’s how my passive income portfolio would grow over time.

YearPortfolio ValueAnnual Dividend Income

By harnessing the power of compound returns, I’d end up with a £2m+ portfolio after 30 years from just £600k in contributions over that period.

Although investing that amount is easier said than done, it could eventually produce an annual passive income stream just shy of £81,000 — not too shabby!

Risks of investing

My analysis rests on some key assumptions. In reality, my stock market holdings may underperform, which would result in a smaller portfolio value.

There’s also a risk that my annual dividend income could be lower if companies I own axed or suspended their dividends.

To mitigate these risks, I’d carefully research my stock picks and diversify across a range of businesses and sectors.

So, where should I begin my search for top dividend shares?, of course.

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.

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.

Charlie Carman has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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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