ISAs (Individual Savings Accounts) are a fantastic vehicle to build wealth. Given enough time, these tax-efficient accounts can help investors generate a large second income from dividend stocks.
Here, I’m going to outline how I’d aim to turn £20k in an ISA into £12k of passive income.
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.
Due to higher interest rates, savers today can thankfully earn a much more respectable return from cash.
However, over the long run, I’d still want to put my money in the stock market. That’s because it has delivered average returns of around 7-10% a year for many decades. This beats the returns from both bonds and savings accounts.
To start investing, I’d need to open either a Stocks and Shares ISA or a Lifetime ISA. The annual allowance for a Stocks and Shares ISA currently stands at £20k a year.
With this sum, I’d build a portfolio of stocks to hold for many years, preferably at least a decade.
Naturally, not every company I invest in will turn out to be a winner. That’s why I’d diversify my portfolio to avoid putting all my eggs in one basket. Doing so would mean that even if a few shares underperform, I can still do well from my other investments.
The great thing for long-term investors is that the maths really are on our side. That’s because I can only ever lose 100% of my invested capital. I personally have never done so, though I’m not far off with one particular share right now (I’m looking at you, Butterfly Network).
While losing 100% of my money on a terrible stock is an unlikely worst-case scenario, it is possible.
Fortunately though, the amount by which an investment can go up is theoretically uncapped. For example, shares of energy drinks firm Monster Beverage are up a mind-boggling 87,466% in 20 years.
One massive long-term winner that delivered even a fraction of this return would offset dozens of duds in my portfolio. The value of winning can therefore far exceed the cost of losing.
Building a quality portfolio
There is no hard-and-fast rule as to how many shares should be in a portfolio. Across my own ISA and SIPP accounts, I tend to hold between 40-60 investments. Any more than that, I start to lose the ability to keep tabs on them all.
But I’d aim for at least 15-20 stocks when starting out. And I’d invest in world-class companies such as pharmaceutical giant AstraZeneca, Johnnie Walker-owner Diageo, and robotic surgery pioneer Intuitive Surgical.
Importantly, I wouldn’t be afraid to ask for guidance. After all, services such as The Motley Fool exist to help investors build high-quality portfolios.
A £12k second income
Now let’s assume that I’m able to save and invest £650 a month. Doing so, my £20,000 would grow to about £170,740 after a decade, assuming an average 9% annual return.
If I then switched to dividend stocks collectively retuning 6%, my ISA could be generating me a tax-free £12k second income every year. That would nicely average out at £1,000 a month across the year, which sounds great to me.
Finally, I should point out that no single dividend is guaranteed. So the same principle of diversification would naturally apply to passive income stocks.