How to turn a £20k ISA into a monthly second income

By leveraging the power of an ISA, investors can start earning a tax-free second income from their investment portfolio. Zaven Boyrazian explains how.

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Dividends can make for a terrific second income. Apart from being paid on a fairly consistent schedule, continued expansion of a firm’s earnings paves the way for continuous boosts to payouts. Some businesses even go on to becoming Dividend Aristocrats, hiking shareholder rewards every year for decades.

It’s a marvellous way of earning some extra cash without having to lift a finger beyond initially hitting the ‘buy’ button. And with a wide range of companies linking their dividend policy to be in line with inflation, earning income this way can also be a powerful hedging tool against the devaluation of money. Best of all, doing it inside a Stocks and Shares ISA keeps the grubby fingers of HMRC away.

Making a plan

There are numerous approaches to building a passive income with dividend-paying enterprises. A lot of income-seeking investors tend to start hunting down high-yield opportunities. After all, if a stock offers a monstrous payout of 10%, then a £20k Stocks and Shares ISA can immediately unlock a £2,000 passive income stream.

However, finding companies able to sustain such a high payout can be quite challenging. Don’t forget that yield is often pushed into double-digit territory due to a rapid decline in stock price. And that’s often a strong indicator of something fundamentally wrong.

Instead, investors may achieve better returns by finding the businesses capable of consistently hiking dividends. Even if the yield today is low, years of continuous payout hikes can send a yield to jaw-dropping levels. In fact, that’s precisely how billionaire investor Warren Buffett earns more than a 50% return on his initial investment in Coca-Cola every year from dividends alone.

Identifying future Dividend Aristocrats

Finding businesses capable of consistently increasing shareholder payouts for decades to come is easier said than done. However, there are some steps investors can take to narrow the search.

To start things off, we need a firm that’s going to stay relevant for decades. It also needs to have a business model that generates plenty of cash enough to cover both the interest on any debt as well as dividends – preferably with plenty to spare.

Foresight Solar Fund (LSE:FSFL) is one such firm that meets all of these criteria. It owns a portfolio of solar farms and energy storage facilities both in the UK and abroad. Its assets generate clean electricity, which is sold to energy providers, consistently generating cash flow.

Unfortunately, building and maintaining renewable energy isn’t exactly cheap. And the firm has racked up a considerable pile of loans on its balance sheet increasing the level of risk. The good news is, Foresight is a highly cash generative business. And to management’s credit, the overall degree of leverage has started to come down and now sits at £429.5m at the end of May 2024 compared to £525m in January 2023.

The group has also started to undo some of its historical equity dilution through buyback steadily reducing the number of shares outstanding while the stock price remains depressed in the current market climate.

That all points to prudent capital allocation in my opinion. So it’s no wonder the group’s already hiked payouts for nine years in a row, generating a lucrative second income stream for long-term investors.

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.

Zaven Boyrazian has no position in any of the shares mentioned. The Motley Fool UK has recommended Foresight Solar Fund. 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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