How I’d turn a £20k ISA into a £10k yearly second income

UK and US dividend stocks offer excellent opportunities for investors to build a long-term second income. Our writer explores his plan.

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Earning a second income can certainly be useful, especially in the current economic climate.

I currently have multiple income streams but my favourite by far is to own dividend shares. This way I can earn a slice of a company’s profit every quarter in the form of dividend payments.

How I’d plan a second income from shares

If I wanted to turn a £20,000 Stocks and Shares ISA into a regular second income, here’s what I’d do.

First, if I aim to earn £10,000 a year, I should note that it would be highly unlikely with just one single £20,000 investment. But given long-term average investment returns of 8%, I calculate that it should be possible with around five yearly £20k investments.

Next, I need to decide what to invest in. Many UK investors first look to the large-cap FTSE 100 index. Right now, it offers a dividend yield of around 4%. But over the past decade it has only managed to grow by 5% a year, including dividends.

That’s far from the 8% return that I’m targeting.

That being said, within the Footsie, there are several excellent dividend shares.

Footsie dividends

For instance, mining giant Rio Tinto offers a 6% dividend and potential earnings growth. Over the past decade, it has provided shareholders with a 10% annual return, including dividends.

Although future performance isn’t guaranteed, it looks like a quality business trading at a reasonable price. And I wouldn’t be surprised to see more of the same over the coming decade.

Other Footsie shares that could provide a chunky second income include Legal & General with its 9% yield. This retirement and investment business offers a progressive dividend policy and has a long history of growing payments over the years.

One thing to bear in mind is not to just look at a company’s yield. It’s important to consider how the business might perform over the coming years too.

Potential value traps

Investors should be aware of potential value traps. These might look like good value at first glance but may not be good long-term investments.

For instance, Imperial Brands offers an 8% dividend income. And although Imperial can comfortably afford these payments from current earnings, its business could struggle in the years ahead, in my opinion.

The tobacco business suffers from heavy regulation and its competitors look better placed to benefit from the shift to newer products. So overall, I think I’ll give it a miss.

Dividend kings

Finally, I wouldn’t just stick to the UK. There are dozens of excellent dividend shares in the US too, especially for long-term investors.

Many of these include dividend kings. These are an elite group of quality stocks that have raised their dividends for 50 years in a row.

Examples include Coca-Cola, Walmart, and 3M.

Dividend growth stocks like these typically offer a modest yield, but over time overall income is likely to grow.

Consider Warren Buffett’s investment in Coca-Cola. When he bought this stock 35 years ago, it offered a 3% dividend yield, much like it is today. But due to rising dividends, earnings, and stock buybacks, its annual dividend payment now represents a near-60% yield on cost.

That’s impressive, and exactly what I’d like to do to build a long-term, solid 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. 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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