How I’d invest a £20k ISA to target a second income worth £1,600 a year!

Dr James Fox explains how he could use his entire Stocks and Shares ISA allowance to generate an annual four-figure second income.

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Generating a second income is the main objective for many investors. Some of us want harvest extra income in the near term, others invest to generate wealth later in life. But it can be easier said than done.

Today, I’m looking at how I could invest a £20k ISA to deliver a huge £1,600 a year. That’s a whopping 8% yield. For me, that’s the very top end of what an investor could realistically look to achieve in dividends without compromising sustainability.

Dividends over growth

If we’re looking for a second income, it makes sense to invest in dividend stocks. Of course, I could use a strategy whereby I invest in growth stocks and take any share price growth as an income. But that’s risky and far more complex.

Dividends are by no means guaranteed. But if I pick well, they are more reliable than investing in growth — that’s my opinion anyway.

Some of the dividend stocks I’m looking at today offer little in the way of share price growth over the long run — at least that’s what historical data suggests. Instead, the returns come almost entirely in the form of dividends.

Second income generation

If I wanted to generate an income worth £1,600 a year from a £20,000 investment, I’d need to invest in stocks averaging a 8% dividend yield

That’s not easy, but recent pressure on certain parts of the stock market has created opportunities for supercharged dividends. Financial stocks were hardest hit as the Silicon Valley Bank (SVB) fiasco sent shockwaves through the industry. Some stocks have recovered, others haven’t.

And that’s where I’m looking — the beaten-down part of the market. That’s because there’s a direct link between share prices and dividend yields. In other words, when share prices fall, dividend yields go up.

After all, the dividend yield at the time of purchase will always be relevant to me, regardless what happens to the share price.

I also need to be looking at metrics for sustainability. The primary one is the dividend coverage ratio (DCR). This measures the number of times a company can pay its current level of dividends to shareholders.

A ratio above two is considered healthy. However, companies with lower DCRs but strong cash flow generation can be considered good dividend stocks.

Top picks

There are a host of dividend stocks with strong yields, but I need to pick some of the highest-paying stocks in order to hit my 8% target. So let’s see which stocks could do the job.

StocksDividend yield
Barratt Developments7.7%
Close Brothers Group7.5%
Legal & General7.8%
M&G 9.8%
Phoenix Group8.9%
Sociedad Química y Minera14%

Investing in these stocks would potentially allow me to maximise my dividend yield. Although I have to accept that my returns could be less than I hope for, I feel there’s a strong chance I could turn a £20,000 ISA allowance into a four-figure income.

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.

James Fox has positions in Aviva Plc, Barratt Developments Plc, Close Brothers Group Plc, Legal & General, Phoenix Group, and Sociedad Química Y Minera De Chile. 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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