How to turn a Stocks and Shares ISA into a source of passive income

Can building a diversified portfolio of dividend stocks and funds within a Stocks and Shares ISA generate a steady stream of passive income?

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Turning a Stocks and Shares ISA into a passive income generator takes time and discipline. However, it can provide tax-free retirement income if done properly. Here’s a step-by-step guide on how to transform an ISA into an income-creating engine.

1. Dividend stocks

The foundation of any passive income portfolio is a setup of high-quality dividend stocks. These tend to be large, established blue-chip companies with steady earnings, solid fundamentals, and a proven commitment to increasing payouts every year. So, if investors are keen on generating passive income via their ISA, they’ll need to find the discipline to invest consistently over time. But perhaps more importantly, they’ll need to reinvest those dividends to allow the power of compounding to work its magic.

Thus, building up a diversified portfolio across a variety of sectors can provide inflation-beating income that rises steadily. For instance, the FTSE 100‘s top dividend payers currently include stalwart giants like Taylor Wimpey, Lloyds, British American Tobacco, Aviva, and Glencore. Thus, populating an ISA with stocks like these that have stood the test of time and kept increasing payouts through thick and thin can pay major dividends.

Reinvesting dividends in the early years accelerates a portfolio’s growth thanks to compounding as well. For example, a £20,000 investment with a 3% dividend yield would produce £600 in the first year. Reinvesting this amount then allows a portfolio to grow in value by an additional £600. By the second year, the larger portfolio throws off even higher dividends, creating a snowball effect over time.

2. Income-focused funds

While individual stocks should form the core of such an ISA portfolio that targets passive income, adding some dividend-focused funds can boost diversification too. Funds like investment trusts allow exposure to hundreds of dividend-paying stocks across various sectors in one single product.

These products can also be subject to less volatility, which could bring investors some peace of mind. As such, funds that specifically target companies with long histories of progressive dividend payouts are a plus.

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, nor 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.

3. Fixed-income alternatives

For investors who want to diversify their Stocks and Shares ISAs further, complementing their dividend stocks and funds with fixed-income sources like bonds, or even bond exchange-traded funds (ETFs) may be a good option. High-quality corporate bond funds and UK gilts can provide stability and income predictability to smooth out dividends’ inherent volatility. After all, certain stocks that have high yields tend to be cyclical in nature.

Therefore, bonds play an important role in providing steady interest income and minimising risk. This is especially for investors in or near retirement. Mixing in fixed-income investments means a balanced passive income stream from both equities and bonds within an ISA’s tax-friendly umbrella.

With a combination of all the asset classes above, most investors should eventually be able to generate a steady stream of passive income. That said, doing so takes patience and discipline. But with time and consistency, an ISA can become a tax-free passive income engine for years ahead.

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.

John Choong has positions in Lloyds Banking Group Plc and Taylor Wimpey Plc. The Motley Fool UK has recommended British American Tobacco P.l.c. and Lloyds Banking Group 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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