How I’d start an ISA to target a second income of £40,803 per year

With a little saving early on, investment in high-yielding stocks, and reinvestment of dividends, I could generate a second income of £40,803 per year.

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Generating a high second income creates a range of choices in life, and starting to build it early is vital. Happily, the FTSE 100 boasts many high-quality shares that pay very high dividends — a key part of this process.

Going for yield

For example, based on last year’s final dividends and current share prices, several stocks yield well over 9%. My favourites among them in ascending yield order are Glencore (9.6%), Phoenix Group Holdings (9.8%), M&G (10.3%), and NatWest (13%). The four stocks’ average payout is 10.7%.

My first ISAs held high-paying stocks like these and in some cases the very same ones. Currently, I have other similar holdings that give me a better opportunity for share price appreciation as well, I think. But if I were starting from scratch now and focusing on yield, then I would buy all four of them.

There is a risk here, of course, of another major financial crisis at some point. This could lead to a period of reduced dividend payouts from FTSE 100 stocks.

Additionally, it might be necessary to substitute different stocks in the mix for those that fall on hard times. This would incur losses from share price depreciation. There could also be tax implications on any capital gains made before any stock was sold.

On the other hand, there could be significant share price appreciation over whatever period I held the shares. This would boost returns even more dramatically.

From the creation of the FTSE 100 in 1984 to the end of 2022, the overall price return was 645.2%. This equates to 5.3% on an annualised basis.

That said, the most tax-efficient way for me to invest would be through a Stocks and Shares ISA. And I would aim to use the full allowance for this, which is £20,000.

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.

If I was on the mean average UK salary of £33,402, then my monthly take-home pay would be around £2,228. If I set aside £417 per month of that, I would have saved £20,000 in just under four years.

The power of dividend reinvestment

Like compound interest, allowing share dividends to be reinvested each year results in a startling multiplier effect on investments.

With this one ISA, after 10 years I could be making around £5,342 in second income. Added to the UK State Pension of £10,600, it would surpass the £13,000 seen as providing a ‘basic’ standard of living pension. Retirement at that point might not be to everyone’s taste but taking a more enjoyable (perhaps less well-paid) job might be.

After 20 years, my second income could rise to £14,764 per year. The addition of the State Pension would surpass the ‘moderate’ standard of living pension of £23,300.

After 30 years, my initial £20,000 investment could have created a total investment pot of £422,142! This would generate £40,803 in second income every year from dividends alone.

This on its own compares favourably to the £37,300 seen as providing a ‘comfortable’ standard of living pension. Add in the State Pension, and the future looks even brighter.

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.

Simon Watkins has no position in any of the shares mentioned. The Motley Fool UK has recommended M&g Plc. 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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