How to aim to turn a £20k ISA into a £10,595 yearly second income!

Our writer explains how UK investors can take advantage of the tax-efficient status of an ISA to earn a sizeable second income.

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Investing in dividend shares can create an excellent second income. For me, the main attraction here is that I don’t have to slog away at a second job in order to generate this extra passive income stream.

Plus, the period of high inflation that we’re all living through underscores how desirable it is to have additional sources of cash.

Generating passive income from an ISA

The Stocks and Shares ISA is a wonderful invention. It allows residents in the UK to invest in stocks without worrying about paying capital gains or dividend taxes. This means it is by far the best vehicle to generate a tax-free second income, in my opinion.

The annual allowance for an ISA today is £20,000. If I invest that lump sum in a basket of dividend stocks that generate 7% a year, my portfolio would pay me around £1,400 annually.

However, if I reinvest those dividends instead of spending them, then I begin to harness the power of compound interest. Doing it this way, my £20,000 could grow to £151,385 after 29 years.

If I then opted to receive my cash dividends, I’d be receiving £10,595 from my portfolio each year.

Now, while that’s an amazing return in itself, I’m hoping to be retired in 29 years. So, to get to my target sooner, I’m going to have throw a few more logs on the fire along the way.

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.

Turbocharging the process

Let’s now assume that I save and invest an extra £500 a month to add to my £20k. In this scenario, assuming the same 7% reinvested annual return, I’d hope to reach £151,385 inside 12 years.

Better still, if my career progresses or I start living more frugally, I could maybe reach a position where I can afford to inject a bit more cash. Perhaps those £500 monthly payments might then eventually average out at £650. If so, I would reach my target in just 10 years!

Therefore, in one decade’s time, I could be generating a yearly £10,595 second income from an initial £20k portfolio that I’d added £650 to every month.

This is a clear demonstration of the power of regular investing. Like many things in life, patience and consistency are the key ingredients for success here.

Keeping my portfolio diverse

Having said all that, it’s crucial to bear in mind that some dividends do get cut occasionally. After all, these are paid from the cash flows of companies, the fortunes of which can change quite dramatically.

For example, UK housebuilders have recently been slashing their shareholder payouts. The reason is the higher interest rate environment that is creating uncertainty and falling prices in the housing market. And this is badly hitting profits in the sector.

Therefore, it’s essential that I build a diversified portfolio to guard against any one or two sectors encountering difficulties. Fortunately, there are dozens of stocks carrying yields between 6% and 8% on the London Stock Exchange right now.

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.

Ben McPoland 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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