My Stocks and Shares ISA is a great way for me to invest in a tax-efficient manner. For example, when trying to build a source of second income, any stock that I own within my ISA that pays a dividend won’t be eligible for dividend tax.
I have an allowance of £20k each year to invest in the ISA. So if I was just starting out now, here’s how I’d build up my portfolio.
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 building blocks
Having an empty ISA to begin with isn’t a disaster. Even if I don’t have any savings, my aim would be to free up some cash flow from my monthly income and expenses. The beauty of an ISA is that I don’t have to invest the full £20k at once. I can put in as much or as little as I’m comfortable with each month (or even more frequently if I want).
The aim of generating high levels of passive income over time is to bank on the compounding effect. This refers to growing my investment at a faster pace by reinvesting dividends over time. For example, let’s say I put £1,000 in a stock that has a dividend yield of 5%. When I get paid the £50 dividend, I buy more of the same stock. Then I have £1,050, which in theory would pay me £52.50 in the next year. Over time, this compounds.
My steps of going from zero to something are as follows. I either cut back on expenses or boost my income to free up cash each month. I invest this money in good quality dividend stocks. When I receive the dividend, I buy more of the same stock. This compounds in coming years, at which I can make a call on when to start enjoying the income.
One to include
I need to find good ideas to start populating the ISA. One example of a stock that I own is Rio Tinto (LSE:RIO). The current dividend yield is 6.37%, with the share price up a modest 2% over the past year.
Let’s address the main risk straight away. It’s true that in the latest annual results, the dividend was reduced, with the annual figure down 12% versus the previous year. Ultimately, this reflects the 19% fall in profit after tax. This was blamed on temporary operational factors and weaker markets with lower commodity prices.
A business like Rio Tinto is always going to be dependant on commodity prices, but I feel that going forward things look much better. For example, the copper price is rallying hard this year with high demand for commercial uses.
Further, the management team know that income is important. It mentioned that “we will continue paying attractive dividends and investing in the long-term strength of our business”. With a high payout ratio of 60%, I’m confident that this would be a good addition to a new ISA.
Show me the money
Let’s say I manage to invest £300 a month on average in stocks like Rio Tinto that have a yield around 6.5%. After a decade, my pot could be worth just over £51k. In the following year, this could pay £3,315 just from dividends.
