The opportunity to secure financial freedom is a real possibility for many people and passive income is the fuel powering it. For some (like me) it’s become their key retirement goal. To build up an income stream that unlocks a treasure chest of financial flexibility.
Fortunately, it’s a goal that’s within reach of most people these days! Here’s a simple strategy to generate a steady second income with a small pot of savings in an ISA.
Hassle (and tax) free
Earning income by investing in companies that pay dividends is a hassle-free and proven method of building wealth. These companies regularly pay a percentage of profits to their shareholders.
But that doesn’t mean it’s risk free. Share prices rise and fall, so any investment could lose money rather than make it. Furthermore, dividend payments are never guaranteed (although changes are announced in advance).
However, there are ways to reduce the risk by selecting companies with a proven track record of making payments. And with a Stocks and Shares ISA, UK citizens can maximise their returns by investing up to £20,000 a year tax free.
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.
The energy giant
One stock I like the look of is National Grid (LSE: NG.), the leading supplier of gas and electricity to the UK. It has a very attractive 7% yield, almost double the FTSE 100 average. And despite not being a growth share, it’s up 23.5% in the past five years. That’s an annualised return of 4.3% — which equates to over 11% when adding dividends.
There are other UK dividend stocks that have higher yields but their payments aren’t as reliable. Even though National Grid recently announced a dividend reduction, it still has one of the best track records in the UK. For over 20 years, payments have been consistent and have grown at a rate of 4.2% per year.
With those figures, a £10,000 investment could grow to £114,180 in 20 years, paying dividends of over £10,000 per year. That’s an annual flow of passive income equivalent to the original investment, in just 20 years!
No guarantee
Of course, National Grid is just one company and it could face any number of issues in the next 20 years. In May, the share price fell rapidly after underwhelming results, leading to the decision to reduce dividends. Typically, a company only does that when it needs the money to fund a business-critical issue.
I hope they’re using those savings to reduce their debt load because it’s very high, at £42.5bn!
For now, interest payments on the debt are sufficiently covered by earnings before interest and tax (EBIT) — but it can’t afford to fall much deeper into debt. If earnings don’t improve, it could spell trouble.
Diversification to the rescue
That’s why I never focus on one stock when considering income from dividends. A single industry like energy is always at risk of localised issues or competition from rivals. Mixing up a portfolio with shares from a range of different sectors such as banking, retail, and biotech, can help protect against industry-specific risks.
Some other reliable UK stocks I would consider for a high-yield dividend portfolio include HSBC, Aviva, Legal & General, and Taylor Wimpey.
