With a new tax year upon us, a whole new ISA allowance starts once more.
I think investing a Stocks and Shares ISA in the right way can help turn it into a powerful passive income machine over the long term.
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.
If I wanted to target a £13,900 second income annually, for example, here are the investment principles I would use when putting my £20k ISA allowance to work.
Taking a long-term approach
Earning £13,900 of income next year from £20,000 would require me to earn a dividend yield of almost 70%.
I do not see that as even remotely realistic. What is realistic though, is to build the dividend yield I earn on an initial £20k investment over time by compounding the dividends.
As an example, if I earned an average 7.5% dividend yield on my ISA and compounded for 31 years, I would then be earning over £13,900 as an annual second income.
Over three decades is a long time to wait. Then again, I think the potential financial rewards justify it.
Sticking to likely strong income producers
Past performance is no guide to what will happen in future. Dividends come and dividends go.
So in building the portfolio for my ISA, I would look to the future and try to find companies I think have the potential to provide long-term income streams.
To illustrate what I would look for, consider as an example Phoenix (LSE: PHNX). The FTSE 100 company operates in a market that is likely to experience large, resilient demand over the long term by providing financial services such as pensions.
It benefits from competitive advantages including strong brands, a large entrenched customer base and deep understanding of specialist markets. It also has a proven ability to generate substantial amounts of cash.
Recently, the company said it plans to keep growing the dividend annually. The yield is already a juicy 10.3%. Note though that I would not buy a company just because of its yield. It first needs to strike me as a great business selling at an attractive price. Only then do I consider its yield.
Spreading my choices
Phoenix faces risks. For example, it has incurred higherthan normal non-operating costs. It expects these to recede once it completes a programme of investing for business growth. However, if that does not happen, such costs could continue to eat into profitability.
I would want to reduce the risk that a single bad choice sinks my long-term income plan. So I would diversify across a range of different shares in my ISA. £20K is ample for that.
Getting started
In theory I think earning £13,900 annually in future from a £20K investment now is possible.
In practice, though, it takes action. So I would take time now to find the best Stocks and Shares ISA I could then use as the basis of my long-term second income plan.
