Turning a £20k ISA into an annual second income of £30k? It’s possible!

This Fool UK writer is exploring how to harness the power of dividend shares and compound returns to build a lucrative second income.

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The new tax year is upon and it’s time to start thinking about new ISA possibilities. With a Stocks and Shares ISA, it’s possible to invest up to £20k a year tax-free and begin the journey towards a lucrative second 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.

How would someone go about doing that?

Well, investing the maximum ISA allowance into stocks that pay reliable dividends is a good start. Reinvesting those dividends to maximise returns is the next step. Building the investment up with regular contributions is the final clincher that hopefully secures the prize.

But there are so many dividend stocks to choose from – which are reliable and which to avoid?

Choosing a great dividend stock

Selecting the right stocks can be a minefield because there’s a lot of factors involved in the selection process. A high dividend yield is a good place to start but it must be backed up by a solid track record of payments. 

Let’s consider Aviva (LSE:AV.)

This long-running and reliable British insurance company has been paying a dividend regularly for over 10 years. Not only that, the dividend has been steadily increasing – and not in an unsustainable way that makes it likely to get cut. Aviva has been careful to offer investors a realistic dividend that won’t put pressure on the company’s profits if times get tough.

Only during the pandemic when almost every industry suffered was Aviva forced to cut a single payment. Payments quickly resumed in the second half of 2020 and have been consistent since. At 7.2%, Aviva boasts a dividend yield that’s higher than most and is forecast to reach 9% in the next three years. 

On the downside, it currently has a slightly high payout ratio of 89%. This means it’s paying out a very large portion of earnings as dividends. Should earnings decline, it may have to choose between reducing the dividend or digging into cash reserves to cover it. For now, the company’s earnings growth is positive and predicted to continue at a rate of 7.8% per year.

However, like most value stocks, Aviva doesn’t experience exceptional share price growth. Over the past five years, the share price has only increased by 9.3%. That’s pretty tame when compared to top growth stocks like BAE Systems and AstraZeneca. This is why it’s important to diversify an ISA portfolio with a few growth stocks even if they have lower dividend yields. 

Where’s that £30k second income?

So what about the aforementioned £30k income? It’s right there, nestling in a good dividend portfolio with regular monthly investments and the magic of compound returns

For example, a decent portfolio can be expected to return on average 7% in dividends with an average annual price increase of 5%. These figures aren’t guaranteed, of course, and can fall as well as rise.

But let’s assume the ISA is invested with the full £20k in year one and receives regular monthly contributions of £200 (or £2,400 a year). If the averages remain consistent, after 10 years it would have grown to £105,600 – paying an annual dividend of £6,600. 

After 20 years the dividend payments would be £24,000 and after 22 years? That’s right, a full £30k a year in dividend payments from a pot that has grown to almost £500k!

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.

Mark Hartley has positions in AstraZeneca Plc, Aviva Plc, and BAE Systems. The Motley Fool UK has recommended AstraZeneca Plc and BAE Systems. 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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