How I’d invest £20k in an ISA for a growing 6% dividend yield

Zaven Boyrazian explores how to find potentially winning dividend shares with high yields for sustainable long-term passive income in an ISA.

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With ample volatility flooding the stock market in 2023, dividend yields have reached some of their highest levels in years. And those leveraging the tax-saving advantages of a Stocks & Shares ISA can potentially establish an impressive passive income stream for the long run.

Fun fact. 78 stocks in the FTSE 350 offer dividend yields ranging from 6% to 17%. And while not all of these payouts will be sustainable, that’s a pretty expansive pool of income stocks to choose from.

Even if an investor sticks to the lower end to avoid risk, that means there’s up to £1,200 of tax-free annual passive income to unlock each year in an ISA. And that doesn’t include the long-term potential should companies start to raise shareholder payouts.

With that in mind, let’s explore how I’d go about building a lucrative income portfolio.

Finding high-quality yields

Usually, a dividend yield in double-digit territory is a giant red flag. Why? Because it suggests investors have very little faith that the underlying business can sustain these payments.

But this isn’t always the case. For example, at M&G, the financial services firm has maintained a yield of around 10% since going public in 2019, increasing its dividends every year.

Impressive track records can help identify potential winners. But investors mustn’t make investment decisions based solely on this. When it comes to dividends, the most important factor is free cash flow. This is what ultimately provides the funds to maintain shareholder payouts. And it’s one of the first traits I look for when investigating candidates for my income portfolio.

If cash flow is getting squeezed, dividends could be next. Some companies hate breaking their dividend streaks. And in some cases, management teams will start taking out loans just to keep shareholders happy.

This can work in the short term. But if cash flows don’t recover as expected, the balance sheet can quickly develop cracks that become difficult to fix.

So if I see the combination of debt and dividends rising while free cash flow is shrinking, it’s almost always a sign of poor-quality passive income to be avoided.

Targeting big dividends

With so many FTSE companies offering high yields, investors are spoilt for choice. But if an investor is aiming for 6%, they aren’t required to solely explore companies with this level of payout. What ultimately matters is a portfolio’s average yield.

That means investors could buy a combination of stocks that offer more and less. And while the latter may not be as impressive, it can help introduce more passive income stability, reducing risk in the process.

Sustainability is also a critical factor to consider. It’s easy to build a high-yield income portfolio. The challenge is creating one that can maintain and even expand its income potential in the long run. And should an investor succeed, £1,200 a year could be just the tip of the iceberg.

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.

Zaven Boyrazian 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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