What’s the best way to build up a fat annual passive income? People with different talents will have different approaches. But I reckon my best chance comes from buying dividend shares in a Stocks and Shares ISA.
We can invest up to £20,000 a year and enjoy all the returns tax-free. That’s a big benefit. And even if I can’t use up my full allowance every year, I want to make the most of it that I can.
Even just a few thousand a year can build up nicely in the long term, if I don’t have to pay tax on the profits each year and can reinvest 100% of my returns.
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ISA millionaires
There are around 2,000 ISA millionaires in the UK right now. So that shows the kind of results that are possible.
A million in an ISA could generate an annual income of £60,000 a year for an investor who can achieve an annual 6% return. And I’d say 6% from UK shares every year is quite a modest target.
Most of today’s ISA millionaires have had the cash to use up their full ISA allowances. And a good few of them started back in the PEP days and converted when ISAs were introduced.
So having plenty of cash to invest, and sticking to it for decades, is the ideal combination.
Investing for income
But those of us with more modest means could still build up to a very healthy passive income to help with our retirements.
My suggested 6% return is, I think, conservative. And if I go for stocks paying high dividends, and don’t mind a bit of short-term risk, I think I’d aim for an ISA return of 8% a year myself. That’s with dividends and share price gains.
The top dividends vary. But right now, investment manager M&G is on a forecast yield of 10%. Insurer Phoenix Group Holdings is on 9.3%, and the British American Tobacco yield is up to 9%.
Invest for a decade
There are risks with all of these. But I always diversify my stocks across sectors to help even out the risks.
So what might I achieve with this approach? Suppose I could invest £500 a month, and reinvest all my income each year into new shares. If I could achieve an average annual return of 8%, after 10 years I’d have a pot of over £90,000.
With the same 8% return, that could then generate £7,250 per year in passive income for me.
The power of compounding
But it’s surprising how much difference a bit more time can make. If I do the same thing for 20 years, I could end up with nearly £290,000 in my ISA. And that could then generate my £20,000 a year for me. It should be a bit more, in fact, nearly £23,000.
So with these sample figures, the second decade would be worth more than twice as much as the first decade. And that shows the power of long-term compound returns.
