Here’s how I’d invest a £20k ISA to target a £10,250 yearly second income

Dividend shares can potentially provide a lucrative second income. Our writer considers his plan to earn an extra five-figure sum a year.

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There are multiple ways to earn a second income. But few allow me to do so without significant effort.

Starting a business or investing in property both require considerable time, effort, and money. Instead, I prefer to invest in dividend shares for a reliable passive income.

By contrast to many other investments, a Stocks and Shares ISA is free from both dividend and capital gains taxes. This offers an excellent incentive to invest, in my opinion.

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.

Fishing for stocks

With thousands of shares on the London Stock Exchange, let’s consider how I can find the best dividend shares to own.

To narrow my options, I’d first filter out unsuitable options. For instance, I’d begin by looking at a dividend yield above 5%. The average yield for FTSE 100 shares is 3.8%. But as I’m focusing on earning a chunky second income, I’d consider a higher target.

Next, I’d disregard all the tiny companies. Shares that have a market capitalisation of under £50m are often less established and can be riskier for investors.

To earn a more stable passive income, I’d stick with the larger, more mature businesses. Bear in mind there are some wonderful small- and mid-sized dividend stocks, but my preference for this goal is big stocks.

How I’d find the dividend payers

Then I’d filter for dividend history and dividend cover. I prefer to own shares that have a long track record of paying regular income to shareholders.

Although it’s not guaranteed they will continue to do so, many companies that have been making payments for decades look more reliable to me.

Dividend cover is a common measure of how affordable a dividend payment is compared with what it earns. I’d look for a figure above 1.2. This suggests it can cover its payout 1.2 times from its current earnings.

Once I’ve narrowed down my options, it’s time for me to make my selection. I’d consider a basket of five to 10 stocks. Ideally, I’d also try to diversify my shares across sectors and industries. This should avoid putting all my eggs in one basket.

Building a reliable second income

Earning a £10,250 annual second income from a single £20,000 investment doesn’t look realistic to me though. That would require significantly more risk. That said, using historical returns, I calculate that I’d need a larger pot worth £128,125.

This might seem like a long-distance target, but my calculations show that if I was able to fill my £20,000 ISA every year, I should reach my goal in around five years.

For an income similar to a State Pension, that sounds like a goal worth pursuing.

Which shares?

Right now, if I had spare cash for this strategy, I’d buy Phoenix Group, Rio Tinto, Imperial Brands, Land Securities, and Natwest Group.

On average, this selection offers an 8% dividend yield. Over time, I’d also expect at least some of these shares to grow.

When owning individual shares, I’d need to monitor them to ensure they remain suitable. But I consider it a small time commitment to earn a generous second 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.

Harshil Patel has no position in any of the shares mentioned. The Motley Fool UK has recommended Imperial Brands Plc and Land Securities 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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