Turning a £20k ISA into a £33,000 passive income machine

A Stocks and Shares ISA can be turned into a powerful vehicle capable of throwing off attractive passive income streams far into the future.

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In order to build a large amount of passive income from dividend shares, I reckon the London Stock Exchange is perfect. There are many UK shares trading cheaply.

Here, I’ll look at how I’d target a second income of over £33k a year, starting with £20,000.

A first crucial step

There are a few things I’d consider no-brainers in life, including wearing a seatbelt, getting enough sleep, and exercising regularly.

In personal finance, saving money for emergencies is obviously crucial. Another for me is a Stocks and Shares ISA.

These incredible accounts allow me to put up to £20,000 each year into the stock market while paying no taxes on the returns I make.

So, before starting my investing journey, I’d open a Stocks and Shares ISA account with a reputable online broker.

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.

A great starter stock

Next, I’d have to decide which stocks to buy.

To narrow down my options, I’d want companies that are established, profitable, and pay dividends.

In my eyes, Diageo (LSE: DGE) ticks these boxes. It is the largest spirits company in the world, with time-honoured brands like Guinness, Smirnoff, and Johnnie Walker in its vast portfolio.

In its last financial year (which ended in June), the firm made an operating profit of nearly $6bn on revenue of $20.5bn. That’s a very healthy operating profit margin of around 29%.

Now, Diageo shares have struggled in recent years, falling around 16% since 2019. Investors have been worried about cash-strapped consumers trading down from its premium brands to cheaper alternatives.

This remains a risk. In its Latin America and Caribbean markets, the company saw a 23% drop in its H1 sales due to a pile-up of unsold booze. This contributed to a 1.4% decline in overall net sales, with operating profits also falling.

If we exclude this region, however, group organic net sales actually grew 2.5% year on year, driven by good growth in Europe, Asia Pacific, and Africa. So there were signs of resilience.

Meanwhile, the share price dip has left the stock trading on a forward price-to-earnings multiple of around 19. And the dividend yield is 2.9%. Both look attractive compared to Diageo’s historical norms.

Long term, I’m optimistic about the firm’s growth potential. Rising disposable incomes in the middle classes of China and India should translate into a steady increase in demand for premium liquors.

And while artificial intelligence might disrupt many things, I don’t see it changing the way we consume beer or spirits. Diageo is the sort of company I see being around for many decades to come.

Passive income generation

Through a portfolio of stocks like this, I reckon it’s realistic to aim for an average return of 8%-9% a year. That’s not guaranteed and there will be ups and down, while dividends are never certain to be paid.

But assuming an 8.5% average return, my £20k would compound to £231,165 after 30 years. That’s with all dividends reinvested back into my ISA.

However, if I choose to invest a further £2,600 each year — the equivalent of just £50 a week — then my final total would be £554,123. Nearly double!

Once I reach this stage, I could be earning just over £33,000 in tax-free annual passive income from a 6%-yielding dividend portfolio.

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.

Ben McPoland has positions in Diageo Plc. The Motley Fool UK has recommended Diageo 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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