£10,000 in savings? That could turn into a second income worth £38,793

This Fool looks at how a lump sum of savings could potentially turn into a handsome second income by investing in high-quality companies.

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Making a second income is the dream for millions of investors out there, myself included.

After all, financial freedom is the goal, right? By making extra cash on the side, it means further down the line I’ll have more disposable income. It also means I’ll have time to do the things I love.

The best way to go about achieving a second income, in my opinion, is by investing in high-quality companies that pay high dividend yields.

Tax-free returns

But how would I plan to achieve this if I had £10,000 tucked away?

Well, we’re now a few weeks into the new tax year. Therefore, I see no better way to put my money to work than by investing through a Stocks and Shares ISA.

Every year, investors receive a £20,000 allowance. What’s brilliant about an ISA is that with the capital gains and dividends I make, I don’t need to pay any tax. As such, it offers a great way to enhance returns.

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.

Buying the best

Next on the checklist is to establish what companies I want to invest my money in. This is difficult, as there’s an array of factors that contribute to finding the right stocks. One I like is British American Tobacco (LSE: BATS).

The business has been paying a dividend regularly for over two decades (25 years). What’s more, during that time the dividend has been steadily rising.

That’s important for me. Dividends are never guaranteed. So, when I see a track record like that, where a company has been paying out even during events such as the global financial crash and the pandemic, I’m more confident investing in the stock.

Today, British American boasts a 9.9% dividend yield. That comfortably clears the FTSE 100 average (3.9%). Looking to the next few years, management has reaffirmed that it’s “committed to continuing to reward shareholders with strong cash returns”.

The business will face challenges going forward that will put it under pressure. This could potentially affect its ability to pay a dividend.

For example, the tobacco industry is becoming extremely unpopular as governments around the world crack down on smoking. This has a direct impact on the firm, as we saw last year when it wrote down the value of its US brands.

But while past performance is no indication of future returns, its track record once again fills me with confidence that the business is dedicated to returning value to shareholders, even through this difficult spell.

Furthermore, while its yield is certainly attractive, there are other factors I like about its shares too. They look dirt cheap, trading on around six times earnings.

The business has also been showing signs of impressive growth recently. For example, its New Categories unit saw organic revenues grow 21% last year.

Generating a second income

Taking British American’s 9.9% yield and applying it to my £10,000 ought to earn me a £990 a year second income. That could come in handy, but it’s some way off my £38,793 target.

To achieve that, I would take a few steps. Firstly, I would simply reinvest my dividends. Alongside that, I would add a further £100 monthly contribution.

Compounding at 9.9% annually, after 30 years my £10,000 would generate £38,793 in interest. Breaking that down, that’s a second income of roughly £3,233 a month.

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.

Charlie Keough has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended British American Tobacco P.l.c. 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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