How to invest £20k in an ISA and aim for a passive income worth £45,520

Investing in dividend stocks is a well-established way to earn passive income. In fact, UK investors can potentially secure a lifelong stream of cash payouts that’s entirely tax-free!

That’s because there’s no tax due on dividends or capital gains from investments sheltered in a Stocks and Shares ISA. With a generous £20,000 annual limit, it’s an attractive option for those seeking to build a sizeable dividend portfolio.

Here’s how I’d try to generate a yearly passive income stream of £45,520 starting with £20k.

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.

ISA ISA baby!

There are different types of ISAs. Navigating the ISA market maze can be daunting for novice investors. Accordingly, it’s worth understanding the differences before making any big financial decisions.

For my passive income goals, I’m ignoring Cash ISAs, Lifetime ISAs, and Innovative Finance ISAs. Instead, I’d put my entire £20k nest egg in a Stocks and Shares ISA.

Dividend investing

Many ISA providers offer a substantial range of investment options, spanning stocks, exchange-traded funds (ETFs), investment trusts, and more.

My preferred approach is to build a diversified portfolio of individual dividend shares selected from leading indexes like the FTSE 100, FTSE 250, and S&P 500.

Diversification’s important because no dividend payments are guaranteed. I don’t want all my eggs in one basket.

There’s no firm rule about how many stocks investors should own. However, holding too few shares could produce a highly concentrated portfolio. Investing in too many could mean investors aren’t undertaking sufficient research into each stock they buy.

Generally, I tend to hold at least 30 stocks in my portfolio, spread across various sectors. For me, this is the sweet spot.

The passive income journey

In theory, the maths is quite simple. Imagine I started by investing a £20k lump sum and continued to invest £500 per month over the coming years.

Now, let’s assume I secured an 8% compound annual growth rate on my portfolio (this is broadly in line with historical stock market returns). By keeping this up for 30 years, I’d finish with the handsome sum of £910,406.

At an achievable average dividend yield of 5%, that portfolio would generate £45,520 in cash distributions every year!

Granted, things may be more complicated in practice. Stock market volatility and poor investment picks could produce insufficient returns to reach my passive income goals. Yet, despite those risks, it’s certainly a realistic ambition.

A FTSE 100 stock to consider

To aim for a passive income portfolio of this size, one Footsie dividend stock worth considering is housebuilder Taylor Wimpey (LSE:TW.).

The company offers a juicy index-beating dividend yield of 6.1%, although it’s worth noting payouts aren’t especially well-covered by earnings.

Promisingly, the new government aims to build 1.5m new homes over five years. Consequently, I’m optimistic about long-term demand for the residential developer’s services.

Not only is Taylor Wimpey well-placed to benefit from Labour’s proposed planning reforms but the prospect of further interest rate cuts could stimulate Britain’s mortgage market too.

Granted, the group will always be vulnerable to economic shocks since the housing market is highly cyclical. Potential investors should bear this in mind.

Nevertheless, I think Taylor Wimpey shares make a solid addition to a passive income portfolio. That’s why I own them.